Variability in Risk-Weighted Assets: What Does the Market Think?

55 Pages Posted: 9 Mar 2020

See all articles by Edson Bastos e Santos

Edson Bastos e Santos

Central Bank of Brazil

Neil Esho

Bank for International Settlements (BIS) - Monetary and Economic Department

Marc Farag

Bank of England - Financial Stability Assessment Division

Christopher Zuin

Bank for International Settlements (BIS)

Date Written: February 25, 2020

Abstract

The global financial crisis highlighted a number of weaknesses in the regulatory framework, including concerns about excessive variability in banks' risk-weighted assets (RWAs) stemming from their use of internal models. The Basel III reforms that were finalised in 2017 by the Basel Committee on Banking Supervision 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 banks' reported regulatory RWAs. Using a panel data set comprising a large sample of internationally-active banks over the period 2001 to 16, we find that there was a wide degree of RWA variability among banks, and that market-implied RWA estimates were persistently higher than regulatory RWAs. We then assess the determinants of this variability, and find a strong and statistically-significant association between our measure of RWA variability and (i) the share of opaque assets held by banks (eg derivatives); (ii) the degree to which a bank is capital constrained; and (iii) jurisdiction-specific factors. These 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 the importance of jurisdiction-specific factors in explaining RWA variability. In addition, we find that RWA variability directly affects banks' own profitability through higher funding costs. Finally, we find that the 2017 Basel III reforms - most notably the output floor - help to reduce excessive RWA variability.

Keywords: bank regulation, capital, Basel III, risk-weighted assets, financial stability

JEL Classification: G20, G21, G28

Suggested Citation

Santos, Edson Bastos e and Esho, Neil and Farag, Marc and Zuin, Christopher, Variability in Risk-Weighted Assets: What Does the Market Think? (February 25, 2020). BIS Working Paper No. 844, Available at SSRN: https://ssrn.com/abstract=3549535

Edson Bastos e Santos (Contact Author)

Central Bank of Brazil ( email )

P.O. Box 08670
SBS Quadra 3 Bloco B - Edificio-Sede
Brasilia, Distr. Federal 70074-900
Brazil

Neil Esho

Bank for International Settlements (BIS) - Monetary and Economic Department ( email )

Centralbahnplatz 2
CH-4002 Basel
Switzerland

Marc Farag

Bank of England - Financial Stability Assessment Division

London
United Kingdom

Christopher Zuin

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

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