Heterogeneity of Bank Risk Weights in the EU: Evidence by Asset Class and Country of Counterparty Exposure

IMF Working Papers, June 9, 2017

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Concerns about excessive variability in bank risk weights have prompted their review by regulators.
The paper provides prima facie evidence on the extent of risk weight heterogeneity across broad asset classes and by country of counterparty for major banks in the European Union using internal models.
It assesses sensitivity of corporate risk weights to different indicators of firm risk.
It examines counterfactual impacts on capital ratios under hypothetical harmonized risk-weight scenarios.

The paper finds heterogeneity in risk weights across broad asset classes and by country of counterparty for major EU banks using internal models.
Corporate risk weights are sensitive to the riskiness of an average representative firm.
Corporate risk weights are not sensitive to a market indicator of a firm’s probablity of default.
Under plausible yet severe hypothetical scenarios for harmonized risk weights:
- Counterfactual capital ratios would decline significantly for some banks.
- Those banks would not experience a shortfall relative to Basel III’s minimum requirements.
- This does not preclude falling short of meeting additional national supervisory capital requirements.

Subject: Banking, Capital adequacy requirements, Credit, Credit risk, External balance assessment (EBA), External position, Financial institutions, Financial regulation and supervision, Money, Mortgages
Keywords: bank, Bank Capital, bank portfolio risk, bank risk measure, Basel III, Capital adequacy requirements, capital framework, Credit, credit exposure, Credit risk, Europe, External balance assessment (EBA), Global, IRB portfolio share, IRB risk weight, market risk share, Mortgages, portfolio risk weight, Regulation, risk, risk component, risk weight, Risk Weights, risk weights capture, SA portfolio decomposition, WP

Analysis based on major banks in the European Union using internal models (IRB).
Considers heterogeneity by broad asset class and by country of counterparty exposure.
Uses hypothetical harmonized risk-weight scenarios described as "plausible yet severe" to derive counterfactual capital ratios.

Variability in internal-model-derived risk weights motivates regulator review and potential harmonization efforts.
Harmonization of risk weights could materially lower capital ratios for some banks, even if Basel III minimums remain met.
National supervisory capital requirements could still be binding for some banks following harmonization, implying supervisory coordination and consideration of national buffers are important.