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The apparent failure of banks to predict whether loans will go bad has important ramifications for regulators and investors because default probabilities are a critical when working out risk-weighted assets (RWA), which are in turn used to calculate the basic measure of bank safety: the core tier one capital ratio. Banks that understate their risk-weighted assets effectively overstate how much capital they have to absorb losses.
The Barclays research is likely to add fuel to the raging fire over whether banks should be allowed to calculate their own risk-weights or should be required to use standardised values.
The Basel Committee on Banking Supervision, which sets global standards, found earlier this year that some banks were holding eight times more capital than others against the same trading book assets, and the group is expected to release a study of banking assets later this month. It is also working on a consultation about whether and how to simplify the capital standards.