Vincent Papa, director of Financial Reporting Policy at the CFA Institute comments on the implications of using RWA density and return om RWA as risk and performance metrics.
As we delve deeper into the bank earnings season, it is worth taking a closer look at two important risk and performance metrics: risk-weighted assets (RWA) density, which is defined as “RWA/total assets,” and return on risk-weighted assets (RoRWA), where RWA rather than either total assets or book value equity is the denominator of this particular profitability metric.
Take for instance HSBC Bank, which recently reported an RoRWA of 1.5% for the year ended 2014. This return is lower than the stated target of 2.2% to 2.6%, but it still stacks up relatively well when compared to average European-wide bank RoRWA during recent years (e.g., 0% in 2008, 1.3% in 2010, and 0.5% in 2012), as shown in a 2013 Bain report (Balancing between Risk and Return). Yet, how effectively investors are able to interpret any particular ratio depends, in large part, on the comparability of the underlying inputs, and RWA is a common input for calculating both RWA density and RoRWA.
Notwithstanding the daunting complexity and fluid state of the Basel capital adequacy rules, the risk-weighting methodology — which necessitates assigning risk weights whilst determining RWAs and thereafter determining the necessary capital requirements — makes both intuitive and economic sense. For instance, a €10 million German government loan, with an assumed though sometimes questionable zero risk-weighting, should have a lower overall risk-weighting and capital allocation than a residential real estate loan of the same magnitude but of higher credit risk. That said, a recurrent concern voiced by investors and other stakeholders in recent years is the limited comparability and the unexplained, and possibly unwarranted, variation of RWAs across countries and banks.
There has also been a question of whether aggregate RWAs effectively signal relative aggregate risk across banks. In other words, is a higher RWA density bank really a riskier bank, or are there phases during the economic cycle in which sounder banks will have a higher proportion of RWAs. The below chart illustrates the multi-period trend of RWA density and RoRWA across a sample of US and EU banks. Though the RoRWA multi-period trends sensibly reflect how bank returns changed through the economic cycle, there is the notable trend of either declining or near flatlining RWA density across these banks that is difficult to readily economically interpret. For the EU banks, a part of the decline can be explained by the shift from Basel I to Basel II requirements (as we explain below).
RWA Density and RoRWA Trend Analysis
In addition to Barclays Capital’s 2012 research (“Bye, Bye Basel,” featured in an FT Alphaville article and various other outlets), which highlighted investors’ mistrust of RWAs, there is a series of excellent papers from the International Monetary Fund, Basel Committee, and several other organizations that shed light on the factors underpinning the variation of RWAs across countries. These include the following:
- Revisiting Risk-Weighted Assets: Why do RWAs differ across countries and What Can be Done About It?
- Working Paper: The credibility of European banks’ risk-weighted capital: structural differences or national segmentations?
- Basel Regulatory Consistency Program: Analysis of risk-weighted assets for credit risk in the banking book
- Basel Regulatory Consistency Program: Analysis of risk-weighted assets for market risk
The factors causing variation include, but are not limited to, the following:
- Variation of business model and asset mix across banks
- Varied levels of adoption of Basel requirements: Basel II requirements, unlike Basel I, allows a variety of methodologies for determining RWAs including internal rating-based (IRB) models. IRB models allow flexibility on the probability of default (PD), loss-given default (LGD), and exposure at default assumptions applied by banks that are deemed to have sophisticated risk-management capabilities. Furthermore, Basel 2.5 requires risk-weighting for market risk while earlier versions of Basel do not.
- Variation in model assumptions (e.g., point-in-time versus through-the-cycle PD, and LGD for low-default asset classes)
- Differences in supervisory requirements across countries
Effectively, RWA differences can be explained, in large part, by differences in business models, asset mixes, methodology, modelling inputs, and supervisory regimes. In addition, observed RWA density differences between US and EU banks (US seems to have higher RWA density) can be explained by differences in accounting offsetting of financial assets requirements during balance sheet presentation that result in relatively lower total assets for IFRS (International Financial Reporting Standards) reporting banks (see update on IFRS offsetting requirements).
That said, across different empirical studies, there is an acknowledgement of unexplained RWA variation. For example, the Basel regulatory consistency assessment of hypothetical portfolio exposures across banks reveals unexplained differences for these similar portfolios, though in theory they should be expected to yield the same level of RWAs.
What are the remedies to the challenges investors face with RWAs and, by implication, derived performance and capital adequacy ratios? Multiple ideas have been proposed, including prohibiting IRB-based methodologies because of their built-in flexibility that undermines the generation of comparable RWAs, a situation that is exacerbated by the limited transparency of underlying inputs within IRB models; imposing constraints on IRB parameter estimates; expanding the mandatory disclosure requirements; and harmonizing the supervisory regimes across countries.