D.he major European banks show their balance sheet risks far too low. That is the result of an examination by the banking supervisors of the European Central Bank (ECB), which was published on Monday. In the five-year investigation of 65 large banks directly supervised by the ECB, the supervisors found more than 5,000 deficiencies in the risk models used by the institutions to calculate their balance sheet risks.
The ECB supervisors prompted the banks to take corrective measures, as a result of which the balance sheet items weighted according to their respective risks, particularly credit risks, rose by 12 percent or around 275 billion euros. According to the ECB, this resulted in an average equity ratio of 0.7 percentage points lower. Nevertheless, the banks may continue to use their internal risk models to calculate their required capital if they remedy the deficiencies complained about within the specified deadlines and the calculation methods meet the legal requirements.
After the financial crisis in 2008, internal risk models became the focus of banking regulators around the world because they gave rise to the assumption that banks were paying off nicely. This means that they show their balance sheet risks to an insufficient extent and therefore hold too little equity as a buffer against losses. The banks oppose that the supervisors have to approve the risk models. In addition, these would be based on our own historical data series and thus enable a more precise recording of the risks than blanket standard approaches.
Preference for government bonds
The fact is that the risk-weighted assets relevant for capital adequacy only make up a fraction of the balance sheet total. For example, risks from government bonds do not have to be backed with equity because they are assumed to be fail-safe for regulatory purposes. As shown by Greece’s haircut in March 2012, this assumption is wrong. However, there has been little progress in the capital adequacy of government bonds. Because in the Basel Committee of Banking Supervisors, which decides on the internationally binding banking rules (Basel IV), there is resistance to this, especially from countries with high national debts such as Japan or Italy.
The internal risk models are severely restricted in the Basel IV rules that are yet to be implemented. The banks have to calculate their capital requirements to 72.5 percent according to the standardized approach for credit risk. This means that the equity requirement calculated using internal models may only be 27.5 percent lower than the standard approach.
More confidence in the models
The aim of the ECB investigation, called “Targeted Review of Internal Models” (Trim), was to make the internal models between the banks easier to compare and thus more reliable. The internal models should only deliver different results if the banks have different risk profiles. The chief supervisor of the ECB, Andrea Enria, described Trim as the largest project of the ECB to date. Trim is helping to level the playing field for European banks, he said. But it was also about refuting the suspicion of fine calculations and strengthening confidence in the internal models.
The audit also affected German banks. For example, Trim had lowered the core capital ratio of the Wiesbaden real estate financier Aareal Bank by 2.4 percentage points in 2018. The Deutsche Apotheker- und Ärztebank had to pay tribute to Trim years ago in the form of a declining equity ratio.
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