Banks’ Financial Strength Isn’t What It Seems

(Bloomberg Opinion) — Twelve years on from the financial crisis, depositors and investors really shouldn’t be doubting whether they can trust the way banks measure their financial strength. But the reasons for skepticism keep coming.

The Bank of England last week signaled some lenders may be underestimating the riskiness of their home loans. Banks that use their own models to make these calculations — typically the bigger, more sophisticated lenders — assign an average risk weight of 10% on their mortgages. The measure is low compared with historic levels, and it’s a fraction of the 35% risk weight that lenders assign to real-estate borrowings when they use a standard model rather than a bespoke approach. That’s a troubling discrepancy.

Even for loans that should be of the same quality, lenders are coming up with different risk metrics. Between banks the figures vary from a 4% to a 17% risk weight, according to the British regulator.

With banks sitting on hundreds of billions of pounds of home loans, their judgment on the riskiness of mortgages has huge repercussions on their financial resilience — more so in the midst of a pandemic. The BOE’s concern is a red flag.

Banks are required to hold a minimum amount of capital against loans, after making adjustments for their relative riskiness. This exercise of calculating so-called “risk-weighted assets” is hugely complex. Outsiders, even auditors, don’t have the means to question the result. The upshot is that banks can appear safer than they are if their calculations crunch out a lower risk-weighted number for their assets than a more conservative approach might produce.

The U.K. banks aren’t alone in facing fresh scrutiny of their models. Sweden’s regulator recently asked the country’s biggest bank, Svenska Handelsbanken AB, to switch to a standard model instead of its own internal model when calculating the risk it takes at its British subsidiary. That portfolio consists of mainly commercial and residential real-estate holdings and accounts for more than 10% of the group’s assets.

As a result of the switch, the 149-year-old Swedish bank’s core capital will take a hit when measured relative to risk-weighted assets, taking about 1.6 percentage points off June’s 18.7% common-equity Tier 1 ratio, according to analysts at UBS Group AG.

Even for a bank that claims to be one of the strongest in the world financially, this erosion of its resilience isn’t a rounding error. Its capital buffers still comfortably exceed the demands of regulators, but Handelsbanken’s premium valuation on the stock market is largely a function of its reputation for capital conservatism.  

The regulator said simply that the time had come to use the same calculation of the U.K. assets’ riskiness at both a subsidiary and group level, and that the move wasn’t Brexit-related. 

This isn’t the first occasion risk weightings have been questioned of late, either. Britain’s Metro Bank Plc is being probed by U.K. supervisors for scoring some assets too generously. Regulators fined Citigroup Inc. the equivalent of $57 million in part because the firm underestimated risk assets at its U.K. unit.

The good news is that Europe’s lenders won’t be able to rely as much in future on their own bespoke “black-box” models for calculating risk. Tougher rules are to be phased in from 2023. That could lead to European banks needing 135 billion euros ($159 billion) in fresh capital, regulators say.

These reforms won’t completely solve the problem, and they’re two years away. There’s a general mood of leniency toward banks right now because of the pandemic. The lenders’ so-called “leverage ratio,” a blunter metric of financial strength that doesn’t account for the riskiness of bank assets, is being temporarily eased. Such forbearance needs to be accompanied by heightened vigilance.

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