Capital floors could spur risk-taking – Swedish FSA

If regulators impose harsh minimums on modelled capital numbers, it will encourage banks to take more risk, a senior bank supervisor has warned.

The Basel Committee on Banking Supervision is working on a system of floors that would prevent modelled risk-weighted assets (RWAs) falling below some percentage of the standardised capital approaches for credit, market and operational risk. Proposals were published in December but did not touch on where the floors should be struck.

"Calibrating the floor much above the true risk would create incentives for banks to take more risk. That is not the overall intent of the framework, so I think the calibration needs to be very careful," says Uldis Cerps, executive director of banking at Swedish prudential regulator Finansinspektionen and a Basel Committee member.

In an interview with Risk, Cerps says it is impossible to say where the floor should be set until a decision has been taken on the design of the system – it could rest on a single, bank-wide floor or a combination of floors that are specific to risk types or businesses. Cerps adds that the Swedish regulator would prefer to see "a very granular floor, especially if it's going to serve as a backstop to risk-weighted asset models."

In addition, Cerps points out that the standardised approaches are all currently being revamped, so it is hard to say what kind of numbers each will generate, and therefore how conservative different floors would be relative to current modelled capital.

Calibrating the floor much above the true risk would create incentives for banks to take more risk

Risk managers have already warned that a floor of more than 75% would destroy too much of the capital advantage models offer, and could push them towards riskier lending. Bankers shared estimates on where they believed the floor would be set to avoid such a scenario, ranging from 10% to 50%.

Higher floors could be easier to game, argued Eduardo Epperlein, global head of risk methodology at Nomura in London. "Let's imagine two trades, A and B, with different risk profiles, yet identical expected revenues. A has a bigger RWA than B, so from an RWA perspective – in keeping with the standardised model – a bank chooses B to maximise its return on RWA. But from an economic perspective, the bank knows that B is riskier than A. Logically it may opt for trade A, because the model says A is economically less risky, and banks want to be prudent. But people from the outside will see the bank is not as well capitalised in terms of RWA, and that's clearly not the outcome you want. But if a bank does the opposite, in principle that could put it at more risk."

Sweden is no stranger to this kind of debate. In 2013, the country introduced a 15% floor on risk weights for residential mortgages, increasing that to 25% in 2014. Cerps says reaction from the industry has varied.

"When we raised risk weights to 15%, we actually got the major support from almost all industry representatives, I think they realised that this is the sensible thing to do. I would not say that the macro-prudential increase [to 25%] was welcomed by the industry in the same enthusiastic manner. I think there were concerns we were overshooting, and there were concerns the risk weights are too high in relation to the risk and that we have gone too far."

The full interview with Uldis Cerps will be available online tomorrow and also appears in the April issue of Risk.