November 9, 2011

Eurozone Banks Boost Capital by Redefining Risk

Tactic undermines point of capital requirements, analysts say

European regulators have told banks that they must boost their capital reserves as eurozone debt worries threaten not just individual countries but the joint currency as well. A number of banks have responded not by cutting dividends or bringing in more cash, but by reclassifying the risk on their existing debt holdings—loans, derivatives and mortgages. While the tactic is legal, it is far from reassuring to a number of officials, analysts and economists, who say it defeats the purpose of the higher reserve requirements.

In a Bloomberg story, Adrian Blundell-Wignall, deputy director of the Organization for Economic Cooperation and Development’s financial and enterprise affairs division in Paris, called the ratio of core capital “meaningless” and said, “By allowing sophisticated banks to do their own modeling, we are allowing the poacher to participate in being the gamekeeper. That risks making core capital ratios useless.”

In October, banks were told by regulators that they must boost core capital to 9% of risk-weighted assets by June of 2012. While options available to do this include cutting bonuses and dividends, raising money from rights offerings or selling off assets, as well as putting a hold on lending operations to retain cash—an action politicians are opposing lest the crisis worsen—a number of banks are changing their risk models.

Spain’s two largest lenders, Banco Santander and Banco Bilbao Vizcaya Argentaria; Italy’s fourth-biggest bank, Unione di Banche Italiane; Commerzbank, Germany’s second-biggest lender; Lloyds Banking Group, Britain’s biggest mortgage lender; and Europe’s largest bank, HSBC Holdings, are among the banks revising their risk-weighted asset model to varying degrees, so that they can redefine such assets in order to reduce the amount of cash they must raise by other means.

Neil Smith, a bank analyst at West LB in Düsseldorf, Germany, said of the move in the report, “It’s probably not the highest-quality way to move to the 9 percent ratio. Maybe a more convincing way would be to use the same models and reduce the risk of your assets.”

The Basel Committee on Banking Supervision has set its own capital standards for banks worldwide independent of those laid out by the European Banking Authority. It said in September that it intended a review of how lenders apply weightings to ensure “the outcomes of the new rules are consistent in practice across banks and jurisdictions.”

That could mean that it might publicly identify lenders gaming the rules, according to an unnamed source with knowledge of the committee’s talks who declined to be identified because the discussions are private.

Sheila Bair, former chairman of the FDIC, has characterized Europe’s adoption of risk weighting “naive.” In a Fortune magazine piece on Nov. 2, she said, “It is in a bank manager’s interest to say his assets have low risk, because it enables the bank to maximize leverage and return on equity, which in turn can lead to bigger pay and bonuses. Indeed, even during the Great Recession, as delinquencies and defaults increased, most European banks were saying their assets were becoming safer.”

Reprints Discuss this story
This is where the comments go.