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There is a trend in this week's regulatory frenzy that should worry all of Europe's banks. Post-crisis, capital ratios are largely expressed as a proportion of risk-weighted assets (usually calculated by the banks themselves), rather than total assets. But the rumble of mistrust about RWAs is getting louder. This week, the Danish regulator criticised the risk weights used by Danske Bank and told it to raise them. And the U.K.'s Prudential Regulation Authority recommended that seven of the country's largest banks increase their RWAs to take account of more prudent risk weights.
Allied to the scepticism around RWAs is a growing enthusiasm for the leverage ratio, or capital as a proportion of total assets. Banks say that, while it is a good backstop, the leverage ratio is too blunt to be used alone. By making no allowances for the types of assets held or the way they are treated, banks say, the ratio encourages risk-taking. Still, this week both the PRA and the Swiss National Bank drew attention to low leverage ratios. And a recent report from Berenberg backed the use of RWAs and said banks should hold 6 to 8 per cent of their assets in equity.
The banks are hardly helping themselves. There is little clarity around the risk weighting (according to one estimate, large banks need 200 million calculations to determine their capital needs). The banks also need to explain variations more clearly – why are Deutsche Bank's RWAs equivalent to 16 per cent of total assets when for HSBC the figure is over 40 per cent? If they want people to trust their RWAs, banks have to give them a reason to do so.
One compromise is the wider use of risk-weight floors for some assets. This is not ideal, and blunter than some banks would like. But one of the reasons bank shares are trading at low multiples is that there is little trust in their capital. Restore that trust, and there are benefits for all.
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