Why Risk-Weighted Capital Regulation Misleads

As the controversy over Basel III Endgame continues, an often overlooked point concerns how risk-weighted capital misleads about the adequacy of bank capital, by which we mean banks having enough investor provided, non-run prone funding to keep default at bay. Regulation has for decades referenced these manufactured measures of capital adequacy that have little to do with bank funding. They have not reduced financial instability or American taxpayer losses. Regulatory assigned risk-weights need to go.

The risk-weighted capital regime relies on regulatory mandates, rather than market input to determine the amount of risk a bank’s assets pose. The consultative process through which risk-weights are determined has always been politicized, as regulators have to negotiate among themselves and with the industry and other interested parties what weights to assign different assets. Business loans get assigned among the highest capital requirements relative to other risky assets, because the others are politically favored.

Examples of favored assets include mortgages and mortgage-backed securities and municipal bonds. Even collateralized debt obligations (CDOs) and sovereign debt of financially unstable countries, which contributed to significant bank losses in the last 15 years have benefited from such political favors. And last year, U.S. Treasury securities, which have risk-weights equal to zero, and therefore no capital requirement, performed poorly due to higher interest rates arising from inflation and the subsequent Fed Funds rate hikes.

Banks that didn’t manage that interest rate risk should have done so. But given that those banks didn’t, having more investor equity to back those holdings would have made those banks more resilient in the face of interest rate risk. Instead, some of the largest banks over the past several years have reported hundreds of billions of dollars in realized and unrealized losses in their securities portfolio. These losses would have threatened these banks’ viability if not for the fact that the public understood that the Federal Reserve would provide the ultimate liquidity backstop to them.

Furthermore, banks almost always have risk-weighted capital ratios that exceed 6 and 8 percent, the threshold required to be deemed “adequately capitalized” and “well capitalized”, respectively. If you believe risk-weighted capital ratios reflect capital adequacy, then banks are almost always solvent and, therefore, we should conclude that problem banks must just be illiquid. Yet tangible book and market measures of equity capital often tell a very different story during periods of distress, indicating that such banks are insolvent (or very close to it).

To see how these ratios perform during periods of distress, take the three failed banks in Spring 2023. A FinRegRag blogpost from last year showed that each bank had a Tier 1 risk-weighted capital ratio above the 8 percent “well capitalized” threshold, yet their market capital ratios were tanking throughout 2022 prior to their failures. Silvergate had a whopping 56 percent Tier 1 risk-weighted capital ratio when it liquidated, even as its market capital ratio also tanked throughout 2022. During the 2007-2009 Crisis, large banks also reported being more than “adequately capitalized” in terms of their Tier 1 risk-weighted capital ratio yet still experienced distress (see Tables A1, A5 and A6 here); low risk-weighted assets, such as CDOs, deteriorated and these banks had to rely on a variety of facilities to keep them afloat.

While we and the industry are both critical of the risk-weighted capital requirements in Basel III Endgame, our reasons are very different.

The industry claims it objects to the Basel III Endgame because it would raise capital requirements, which would reduce lending. Claims like that merit further scrutiny. It is true that banks (especially larger banks) that do not want to increase equity funding will reduce their holdings of high risk-weight assets, such as business loans, but it’s also true that banks (especially smaller banks) with more equity funding lend more through the business cycle. As a recent Federal Reserve staff study found, it doesn’t necessarily follow that more capital means fewer loans as the industry would have you believe.

Keep in mind that it was Congress that passed the International Lending Supervision Act of 1983, which gave rise to Basel risk-weighted capital, to get banks in the US and abroad to fund with more equity. Prior to the 1988 Basel Accords, banks funded with roughly 5 percent equity. The Basel Guidelines promised to increase that to 8 percent, except that the risk-weighting of assets effectively resulted in higher reported risked weighted capital ratios, and little change in actual equity. The industry may tout that book equity to assets for large banks has risen to 6-8 percent now—20 to 60 percent more capital. But that is off an historically low level of capitalization and overstates the improvement. How much higher could leverage ratios be?

A recent Bloomberg editorial states that academic studies show that you could avoid bailouts with a 15 percent leverage ratio. One of us, in a co-authored study found that in most cases, the benefits of just using a 15 percent ratio generally outweigh the costs. In the baseline case, the optimal leverage ratio assuming limited benefits and high costs equaled 19 percent, but there were also many cases where the optimal ratio was in the 20-30 percent range, consistent with what Anat Admati and Martin Helwig have long suggested.

After more than thirty years of experience, it is evident that risk-weighted capital fails to identify whether a bank is adequately capitalized. Rather than continue the seemingly endless and laborious process of revising the risk-weighted capital ratios, which few fully understand, there’s a simpler alternative in the form of the leverage ratio. It tells regulators and the public what it needs to know: just how much a bank’s investors can lose before the institution is insolvent, requiring the taxpayer to step in to bail it out. Relying on the leverage ratio, rather than risk-weighted capital ratios, would improve transparency around measuring and judging what is adequate capital.