Dec 05 - Risk weight floors, like the one recently proposed in Sweden for domestic mortgages, could reduce the risk of underestimated losses and capital requirements arising from the aggressive modelling of risk weights, Fitch Ratings says. We expect risk weight floors to be introduced by more national regulators in 2013 to limit the overstatement of regulatory capital.
The problems with the denominator in Basel capital ratio - risk weighted assets (RWA) - have been highlighted recently by the Bank of England and the Liikanen Group, particularly for real-estate lending. A number of initiatives are addressing the wide discrepancy in risk weights based on banks’ internal models, including a consistency review by the Basel Committee.
A stricter regime for the risk weight calculation could be introduced in the UK, Switzerland and other Nordic countries, especially for residential mortgages where internal models calculate relatively small capital requirements. There is some justification for the very low risk weightings for mortgages in some European countries given their extremely strong performance historically, even through downturns. However, this results in minimal levels of capital being set aside for unexpected losses that could turn out to be worse than history projects. Also, some mortgage products are still to be tested in an economic downturn.
The most likely regulatory approach would be to introduce a risk weight floor, as suggested by the Liikanen group. We expect the floors to range between 15% as proposed in Sweden, and 35% under the standardised method.
For commercial real estate, a slotting framework like the one being introduced in the UK, would increase the regulatory capital set aside to cover the risks above the amount calculated by internal models. Under the slotting regime, loans are classified into one of five risk categories, each with standardised risk weights. We expect other regulators to adopt stricter criteria for the calculation of risk weights for real estate loans.
The regulators could limit underestimated losses by introducing capital buffers. The Swiss National Bank considered activating a countercyclical capital buffer to dampen the strong momentum in domestic residential mortgage and real estate markets in August 2012. A flexible capital cushion that increases in favourable and decreases in unfavourable economic conditions, is a sensible way to address unexpected losses. However, excessive or misaligned capital charges could render regulatory risk estimates and models irrelevant for internal risk management.
We agree that current RWAs are highly variable across institutions and can be inadequate for real-estate lending. There are several inconsistencies in internal, model-based, capital estimates - particularly in residential property. We make allowances for this in our analysis, including placing emphasis on leverage as well as risk-weighted capital metrics.
Greater transparency and consistency of risk weights would aid comparability across banks and over time. We believe the banks should prioritise the switch to more granular information on capital and RWAs as recommended by the Enhanced Disclosure Task Force, including tabulation of major portfolios showing average probability of default, loss given default and exposure at default. The disclosure of a RWA flow statement that reconciles movements by risk type since the prior reporting date could support analysis of the significant RWA drivers.