Variability in risk-weighted assets: what does the market think?

Focus

The pre-crisis regulatory framework provided banks with a large degree of discretion in determining their capital requirements. This resulted in excessive variability in banks' capital requirements, which ultimately undermined the credibility of the risk-weighted capital framework at the peak of the global financial crisis. The Basel III post-crisis reforms developed by the Basel Committee seek to reduce this variability. How successful will they be in achieving this outcome?

Contribution

The paper develops a new approach to measuring variability in banks' risk-weighted assets (RWAs), which compares a market-implied estimate of a bank's risk profile with the bank's own estimate. This variability ratio provides an external benchmark to assess the degree of difference in modelled capital requirements across banks and over time. It also provides a quantitative measure to assess the extent to which this difference has narrowed as a result of the Basel III reforms.

Findings

Over the period 2001 to 16, there was a wide degree of RWA variability among banks. Market-implied RWA estimates were higher than those modelled by banks.

What drove this variability? We find a significant association between the degree of RWA variability and (i) the share of opaque assets held by banks (eg derivatives); (ii) the degree to which a bank is constrained by its capital requirements; and (iii) jurisdiction-specific factors. Put differently, market participants 'penalise' banks with such features relative to other banks.

And what about Basel III? We find that the 2017 Basel III reforms - most notably the output floor - help to reduce excessive RWA variability.

Abstract

The global financial crisis highlighted a number of weaknesses in the regulatory framework, including concerns about excessive variability in banks' risk-weighted assets (RWAs) stemming from their use of internal models. The Basel III reforms that were finalised in 2017 by the Basel Committee on Banking Supervision seek to reduce this excessive RWA variability. This paper develops a novel approach to measuring RWA variability - the variability ratio - by comparing a market-implied measure of RWAs with banks' reported regulatory RWAs. Using a panel data set comprising a large sample of internationally-active banks over the period 2001 to 16, we find that there was a wide degree of RWA variability among banks, and that market-implied RWA estimates were persistently higher than regulatory RWAs. We then assess the determinants of this variability, and find a strong and statistically-significant association between our measure of RWA variability and (i) the share of opaque assets held by banks (eg derivatives); (ii) the degree to which a bank is capital constrained; and (iii) jurisdiction-specific factors. These results suggest that market participants may be applying an 'opaqueness' premium for banks that hold highly-complex instruments, and that the incentive for banks to game their internal models is particularly acute for capital-constrained banks. The results also point to the importance of jurisdiction-specific factors in explaining RWA variability. In addition, we find that RWA variability directly affects banks' own profitability through higher funding costs. Finally, we find that the 2017 Basel III reforms - most notably the output floor - help to reduce excessive RWA variability.

JEL classification: G20, G21, G28

Keywords: bank regulation, capital, Basel III, risk-weighted assets, financial stability