31 January 2013

Basel Committee publishes Report on the regulatory consistency of risk-weighted assets for market risk

The report brings together two pieces of analysis. The first is based on an examination of publicly available bank data for a selection of large banks. It also contains the results of a hypothetical test portfolio exercise, in which 15 internationally active banks participated.

The report presents preliminary estimates of variation in risk-weighted assets for market risk (mRWAs) across banks and highlights aspects of the Basel standards that contribute to that variation. Based on publicly available reports, the analysis shows considerable variation in average published mRWAs. While there was some indication from the public data that differences in the composition and size of trading positions are correlated with banks' average mRWAs, the quality of disclosures was found to be insufficient to allow investors and other interested parties to assess how much of the variation reflects differing levels of actual risk and how much is a result of other factors.

The hypothetical test portfolio exercise indicated that, based on the use of a hypothetical diversified portfolio consisting primarily of simple long and short positions, there can be a substantial difference between the bank reporting the lowest mRWAs and the bank reporting the highest. This range of outcomes is attributed to a number of factors:

• A sizeable portion of the variation is due to supervisory decisions applied either to all banks in a jurisdiction or to individual banks. An example of the former would be policy decisions to restrict modelling options (eg to disallow any diversification benefit between types of risk). An example of the latter would be the application of supervisory multipliers: around one- quarter of the total variation in the hypothetical diversified portfolio could be attributed to this single factor. These supervisory actions typically result in higher capital requirements than would otherwise be the case but can also increase the variation in mRWAs between banks, particularly across jurisdictions. These supervisory actions, particularly at an individual bank level, are also typically not disclosed.
• Another important source of variation is due to modelling choices made by banks. The exercise found that a small number of key modelling choices are the main drivers of the remaining model-driven variability. The Basel standards allow some flexibility in measuring risks and some variation in mRWAs should therefore be expected. This study did not seek to determine what the optimal level of variation should be, but the preliminary findings highlight potential policy options that can be considered if the Committee wished to narrow the potential for variation in the future.

While hypothetical test portfolios can overcome the limitations encountered when attempting to use public and supervisory data - as they control for differences in portfolio composition - they only show potential and not realised variation in outcome. Moreover, in this case the exercise focused not on real-life portfolio outcomes but rather on a series of simple long and short positions, designed to reveal the impact of model design features. To shed more light on the effect of different sources of variation on more realistic portfolios, the Basel Committee plans to conduct a further hypothetical test portfolio exercise later this year. This will include other, more complex, hypothetical test portfolios, with the aim of helping the Committee to deepen its analysis of the variation in risk measurement of trading books across banks.

Commenting on the report, Stefan Ingves, Chairman of the Basel Committee and Governor of Sveriges Riksbank, said: "While some variation in risk weightings should be expected, excessive variation arising from bank modelling choices is undesirable when it does not reflect actual risk-taking. These preliminary findings will feed into the policy work already initiated by the Basel Committee, in particular regarding the enhancement of bank disclosures and the fundamental review of the trading book. Also, the analysis used to compile this report provides national supervisors with a much clearer understanding of how the risk models of their banks compare with those of international peers. This will allow national supervisors to take action where needed."

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