16 December 2013

Hagendorff & Vallascas: Bank capital requirements - Risk weights you cannot trust and the implications for Basel III

The authors' results raise doubts over whether the revisions to capital requirements which are in the processes of being implemented will be sufficient to ensure that banks hold capital in line with their portfolio risk.

The Basel III revisions are designed to increase both the quantity and quality of minimum capital holdings by further enhancing the risk sensitivity of capital requirements. As regards increases in risk-weighted assets relative to Basel II, the Basel Committee (2011: 31) reports that “a 1.23 factor is a rough approximation based on the average increase in [risk-weighted assets] associated with the enhancements to risk coverage in Basel III relative to Basel II”. However, as long as the regulatory concept of risk exposure underlying the computation of risk-weighted assets remains only weakly related to risk, the proposed increases in capital requirements are unlikely to align capital holdings with the effective riskiness of bank asset portfolios. The risk sensitivity of capital requirements the authors report is of such a low magnitude that they question whether Basel III will improve the relationship between capital requirements and risk in an economically meaningful way. The projected increase in risk-weighted assets under Basel III suggests that – even under a minimum capital ratio of 13 per cent – banks in the authors' sample will only be required to hold, on average, 1.94 per cent of additional capital per unit of assets. Such an increase is unlikely to make minimum capital requirements more reflective of bank portfolio risk in an economically meaningful way.

The authors' findings support a much more profound overhaul of capital adequacy rules than currently proposed. In line with the authors' findings, Admati and Hellwig (2013) call for an increase in capital requirements (based on unweighted assets) well into double-digit territory to improve the safety of the financial system. Naturally, concerns over bank lending means that the phasing-in of higher capital requirements will have to be carefully managed by policymakers (Calamoris 2013) and complemented by tight and efficient supervision that minimises banks’ ability to game the system. However, it is equally clear that the risk-sensitivity of the Basel capital adequacy framework is inadequate, and attempts by Basel III moderately to improve the risk sensitivity of capital requirements will not be able to address this issue.

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