BIS published a working paper that presents a new approach to measuring variability in the risk-weighted assets (RWAs) of banks. The approach presented in the paper 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 modeled 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.
The global financial crisis highlighted a number of weaknesses in the regulatory framework, including concerns about excessive variability in bank RWAs stemming from their use of internal models. The Basel III reforms that were finalized in 2017 by BCBS 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 reported regulatory RWAs of banks. Using a panel data set comprising a large sample of internationally active banks during 2001-2016, the study found that there was a wide degree of RWA variability among banks and that the market-implied RWA estimates were persistently higher than regulatory RWAs. Regulatory RWAs are roughly half the level of the market-implied RWAs.
Regarding determinants of this variability, the authors have found a strong and statistically significant association between the measure of RWA variability and the share of opaque assets held by banks (example derivatives); the degree to which a bank is capital constrained; and the jurisdiction-specific factors. The 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 jurisdiction-specific factors which could also explain RWA variability. The results point out that RWA variability directly affects banks’ own profitability through higher funding costs. Finally, it was found that the 2017 Basel III reforms, and in particular the output floor, help reduce RWA variability, with greater reductions in variability observed for higher calibrations of the floor.
Related Link: Working Paper
Keywords: International, Banking, Basel III, Capital Requirements, Risk-Weighted Assets, Variability Ratio, Output Floor, Research, BIS
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