Revisiting Risk-Weighted Assets

Revisiting Risk-Weighted Assets. By Vanessa Le Leslé & Sofiya Avramova
IMF Working Paper No. 12/90
Mar 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25807.0

Summary: In this paper, the authors provide an overview of the concerns surrounding the variations in the calculation of risk-weighted assets (RWAs) across banks and jurisdictions and how this might undermine the Basel III capital adequacy framework. They discuss the key drivers behind the differences in these calculations, drawing upon a sample of systemically important banks from Europe, North America, and Asia Pacific. Then, the authors discuss a range of policy options that could be explored to fix the actual and perceived problems with RWAs, and improve the use of risk-sensitive capital ratios.


Introduction

Strengthening capital ratios is a key priority in the aftermath of the global financial crisis.  Increasing the quantity, quality, and transparency of capital is of paramount importance to restore the banking sector to health. Recent regulatory reforms have primarily focused on improving the numerator of capital ratios, while changes to the denominator, i.e., riskweighted assets (RWAs), have been more limited.

Why look at RWAs now? Confidence in reported RWAs is ebbing. Market participants question the reliability and comparability of capital ratios, and contend that banks may not be as strong as they are portrayed by risk-based capital ratios. The Basel Committee recently announced it will review the measurement of RWAs and formulate policy responses to foster greater consistency across banks and jurisdictions.

The academic literature on capital is vast, but the focus on RWAs is more limited. Current studies mostly emanate from market participants, who highlight the wide variations existing in RWAs across banks. There is no convergence in views about the materiality and relative importance of these differences, and thus no consensus on policy implications.

This paper aims to shed light on the scale of the RWA variation issue and identify possible policy responses. The paper (i) discusses the importance of RWAs in the regulatory capital framework; (ii) highlights the main concerns and the controversy surrounding RWA calculations; (iii) identifies key drivers behind the differences in RWA calculations across jurisdictions and business models; and (iv) concludes with a discussion on the range of options that could be considered to restore confidence in banks’ RWA numbers.

A comprehensive analysis of broader questions, such as what is the best way to measure risk or predict losses, and what is the optimal amount of capital that banks should hold per unit of risk, is beyond the scope of this study. A comparison of the respective merits of the leverage and risk-based capital ratios is also outside our discussion.

Conclusion

Perceived differences in RWAs within and across countries have led to a diminishing of trust in the reliability of RWAs and capital ratios, and if not addressed, could affect the credibility of the regulatory framework in general. This paper is a first step towards shedding light on the extent and causes of RWA variability and to foster policy debate.

The paper seeks to disentangle key factors behind observed differences in RWAs, but does not quantify how much of the RWA variance can be explained by each factor. It concludes that a host of factors drive differences in RWA outputs between firms within a region and indeed across regions; many of these factors can be justified, but some less so. Differences in RWAs are not only the result of banks’ business model, risk profile, and RWA methodology (good or bad), but also the result of different supervisory practices. Aiming for full harmonization and convergence of RWA practices may not be achievable, and we would expect some differences to remain. It may be more constructive to focus on improving the transparency and understanding of outputs, and on providing common guidance on methodologies, for banks and supervisors alike.

The paper identifies a range of policy options to address the RWA issue, and contends that a multipronged approach seems the most effective path of reform. A combination of regulatory changes to the RWA regime, enhanced supervision, increased market disclosure, and more robust internal risk management may help restore confidence in RWAs and safeguard the integrity of the capital framework. Finally, the paper contends that even if RWAs are not perfect, retaining risk-sensitive capital ratios is still very important, and the latter can be backstopped by using them in tandem with unweighted capital measures.

This paper aims to encourage discussion and policy suggestions, while the Basel Committee undertakes a more extensive review of the RWA framework.

Accounting Devices and Fiscal Illusions

Accounting Devices and Fiscal Illusions. By Timothy C. Irwin
IMF Staff Discussion Note SDN/12/02
March 28, 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25795.0
ISBN/ISSN: 978-1-61635-386-5 / 2221-030X

A government seeking to reduce its deficit can be tempted to replace genuine spending cuts or tax increases with accounting devices that give the illusion of change without its substance, or that make the change appear larger than it actually is. Under ideal accounting standards, this would not be possible, but in real accounting it sometimes is. For example, governments can sometimes sell assets or borrow money and count the proceeds as revenue, or defer unavoidable spending without recognizing a liability. In each case, this year’s reported deficit is reduced, but only at the expense of future deficits. The result is that the reported deficit loses some of its accuracy as a fiscal indicator.

The use of accounting stratagems cannot be eliminated, but several things can be done to reduce their use or at least bring them quickly to light. Governments can be encouraged to prepare audited financial statements—income statement, cash-flow statement, and balance sheet—according to international accounting standards, and statisticians, who in many countries use accounting data to compile the most important (“headline”) fiscal indicators, can be given the resources and independence to be both expert and impartial, as well as the authority to revise standards in the light of emerging problems. To help reveal remaining problems in headline fiscal indicators, a variety of alternative fiscal indicators can be monitored, since a problem suppressed in one fiscal indicator is likely to show up in another.  Many of the devices documented in this note would be revealed if governments also reported change in net worth and high-quality long-term forecasts of the headline indicator of the deficit under current policy.