Jonathan A. Neuberger

English

Research Papers in Economics

FRBSF WEEKLY LETTER
Number 92-02, January 10, 1992
Risk-Based Capital Standards
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Banks in the u.s. must meet several regulatory
standards for minimum levels of capital. The
primary purpose of bank capital is to serve as a
cushion to absorb losses. Traditionally the size of
this cushion has been set as a fixed percentage of
bank assets. In recent years, capital requirements
have been changed to reflect certain dimensions
of bank risk. By year-end 1992, U.s. banks must
satisfy the international risk-based standards pro-
mulgated by the Basel Committee on Banking
Regulations and Supervisory Practices.
in contrast to fixed capital requirements, the
risk-based standards establish a variable capital
cushion based on the risk of a bank's assets.
These standards assign risk weights to different
categories of assets, and thus create incentives
for banks to shift their portfolios toward assets
that receive favorable risk weights and away from
less favored asset categories. These portfolio
shifts are desirable as long as the weights accu-
rately reflect the true risk of the assets. If the
weights are inappropriate or arbitrary, however,
tbe risk-based standards could actually increase
bank risk. In this Weekly Letter, I describe recent
changes in the composition of bank portfolios
and consider some of the consequences of these
portfolio shifts.
Conceptually, risk-based capital standards are
an improvement over fixed capital regulations
because they explicitly acknowledge the heter-
ogeneity of bank assets. Under traditional regu-
lations, two banks with the same quantity of
assets, but with different asset risks, are required
to maintain the same minimum capital cushion.
Risk-based guidelines, in contrast, recognize that
the riskier bank has a higher probability of de-
fault, and require it to hold a larger capital
cushion against losses.
This variable capital requirement is especially
important in the presence of fixed-price deposit
insurance. The two banks considered above pose
significantly different risks to the deposit insurer.
Under fixed capital regulations, the bank with
the riskier asset portfolio receives a larger sub-
sidy from deposit insurance. Properly adminis-
tered risk-adjusted capital requirements can
eliminate the insurance subsidy, and thus reduce
the incentive to exploit that subsidy by assuming
more risk.
Risk-based capital standards
While bank capital regulation is not new, risk-
based capital standards are a recent pheno-
menon. In 1988, the so-called Basel Committee,
under the aegis of the Bank of International Set-
tlements, presented an agreement among regu-
iators from Europe, North America, and japan
describing a risk-based system of minimum capi-
tal standards that all banks should satisfy. Though
the Committee has no official jurisdiction, regu-
lators in the different countries issued domestic
capital guidelines that largely accord with the
Basel agreement. These guidelines must be met
in full by the end of 1992.
Under these standards, banks are required to
maintain capital equal to at least 8 percent of
risk-adjusted assets. Capital is divided into two
components which are ranked according to the
availability of the funds to buffer losses. So-called
Tier 1 capital consists primarily of common equi-
ty, while Tier 2 can include subordinated debt
and such instruments as cumulative perpetual
preferred stock. Tier 1 capital must comprise at
least 4 percent of risk-adjusted assets.
The risk-adjusted aspect ofthe capital standards
involves allocating bank assets to different cate-
gories, each of which has a risk weight. These
weights were determined by considering the
credit risk of assets. For example, the asset cat-
egory considered to have the lowest credit risk
includes cash and central government securities
(like Treasury bonds). This category receives a
zero risk weight. This means that banks are not
required to hold capital against these safest of
assets.
In contrast, the highest risk category includes
most loans to private entities (such as commer-
cial and industrial loans) and receives a 100FRBSF
percent risk weight. Against these assets, banks
must maintain the full 8 percent capital support.
In between these extremes, there is a 20 percent
risk weight category, which in the U.S. includes
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gage Association (FNMA) and the Federal Home
Loan Mortgage Corporation (FHLMC), and a 50
percent risk weight category which includes resi-
dential mortgage loans. The standards also ac-
count for credit risk associated with off-balance
sheet activities like interest rate swaps and stand-
by letters of credit. Total risk-adjusted assets are
the totals in each category, multiplied by the cor-
responding risk weight. Note that a bank could
have zero risk-adjusted assets if it holds only the
safest assets. According to the risk-based capital
guidelines, such a bank would be required to
hold no capital. To avoid anomalies like this, U.S.
regulators issued an additional requirement that
banks must hold at least 3 percent capital to un-
adjusted assets.
Some pros and cons of
risk-based capital guidelines
The risk-based capital standards have been crit-
icized for arbitrarily assigning risk weights to
different asset categories. For example, the stan-
dards treat every home mortgage held by banks
as being half as risky as every commercial loan.
Undoubtedly, this is not correct in all cases, even
though home mortgages historically have tended
to be less risky than commercial loans.
The risk weighting scheme used in the capital
standards also ignores variations in asset quality
within categories. This means that a short-term
bank loan to a blue chip corporate borrower is
considered just as risky and requires just as much
capital support as a long-term loan to a high-risk
startup venture. The capital standards thus ignore
information relevant to individual asset risk.
The risk-based capital standards overlook poten-
tially important interactions between individual
assets. The standards establish the relative risk
weights based on an asset's risk in isolation of
other assets. Portfolio theory suggests, however,
that the relevant risk of an asset is its risk in port-
folio. Thus, an individual asset's contribution to
portfolio risk depends not only on its own vari-
ability but also on its covariation with other
assets in the portfolio. These latter effects are
ignored in the risk-based standards.
Finally, the risk-based capital guidelines consider
only credit risk in differentiating bank assets
while ignoring other risks, such as interest rate
risk. Thus, any Treasury security, regardless of
term to maturity, is treated as if it poses no risk
to the bank holding it. While this may be true for
default risk, long-term bonds are far more sensi-
tive to changes in interest rates than short-term
Treasury bills.
These criticisms suggest that the risk-based capi-
tal guidelines may not present an aCCuiate pic-
ture of bank risk, and thus may require banks to
hold an inappropriate amount of capital. De-
fenders of the standards, however, counter these
arguments by suggesting that the different risk
categories are broadly consistent with the per-
ceived riskiness of bank assets. While exceptions
can always be found, central government debt is
less risky than obligations of government-spon-
sored enterprises, which in turn are safer than
claims against private sector borrowers. A recent
study by Avery and Berger (1991) provides further
support for the risk-based standards, finding sta-
tistical evidence that risk-based capital is more
informative about bank performance and risk
than unadjusted capital ratios.
Proponents of the risk-based capital standards
also admit that the failure to incorporate interest
rate risk is a real limitation. However, most bank
regulators believe that credit risk is the primary
risk facing banks. While some banks may have
significant interest rate risk in their portfolios, the
major cause of bank failures is more likely bad
management and poor asset quality, and not
excessive interest rate risk. Moreover, bank
examiners continue to rely on subjective eval-
uations of bank portfolio diversification, loan
quality, and interest rate risk management prac-
tices. While the risk-based capital guidelines
do not formally address these factors, they still
receive considerable scrutiny from bank
examiners.
Shifting portfolios
A bank regulatory system that establishes prefer-
ential treatment for certain types of assets relative
to others creates incentives for banks to alter the
composition of their portfolios. A look at bank
balance sheets over the past few years confirms
that significant portfolio shifts have occurred that
are consistent with such incentives. For these
comparisons, I use data from the reports of
condition on insured commercial banks (Call
Reports) for the fourth quarter of 1987 (before the
risk-based guidelines were announced) and the
fourth quarter of 1990.
During this three-year period, banks maintained
their securities portfolios at a constant 19 percent
of total assets. However, they altered the com-
position of these portfolios. Commercial bankholdings of U.S. government securities rose from
65 percent of total securities in 1987 to 74 per-
cent of securities holdings in 1990. Similarly,
bank holdings of government sponsored, mort-
gage-backed securities, so-called Ginnie Maes,
Fannie Maes, and Freddie Macs, rose from 15
percent of bank securities portfolios in 1987 to
25 percent in 1990. These figures indicate that,
while banks maintained the relative size of their
securities portfolios, thev shifted about 20 per-
cent of th~ir holdings into assets with the I~west
risk weights under the Basel accord.
Significant shifts also have occurred in bank loan
portfolios. While total loans were stable at ap-
proximately 62 percent of total bank assets, the
proportion of these loans to finance residential
real estate rose from 17 percent of total loans in
1987 to 22 percentby the end of 1990. In con-
trast, commercial and industrial loans fell from
30 percent of bank loans in 1987 to less than 27
percent in 1990, and loans to individuals held
steady at 20 percent of bank loan portfolios in
both years.
These portfolio shifts are undoubtedly due to
additional factors besides implementation of the
risk-based capital standards. The decline in busi-
ness loans, for example, is partially the result of
the recession that began in July 1990 as well as
intensified competition from nonbank sourCes of
finance. Similarly, the greater share of real estate
finance in bank portfolios has been aided by the
decline of the thrift industry. While all of these
influences affect the behavior of lenders and bor-
rowers, the portfolio shifts that have occurred are
consistent with banks increasing their holdings of
risk-preferred assets under the risk-based capital
guidelines.
If the asset categories under the new standards
truly reflect the risks of broad groups of bank
assets, then the shift toward risk-preferred cate-
gories means that banks have reduced the credit
risk of their portfolios. As bank holdings of assets
in the zero, 20, and 50 percent risk weight
groups increase, then a given level of industry
capital supports a safer portfolio of assets.
Viewed in this light, the portfolio shifts are a
desirable outcome of implementing the Basel
agreement.
While these shifts may be beneficial for the safety
ofthe banking system, they likely will alter the
allocation of credit in the economy. The risk-
based capital standards make real estate loans
and certain securities more attractive to hold
while increasing the relative cost of business
loans. As banks respond by raising their holdings
of Treasury and mortgage-backed securities, and
home mortgage loans, it may become more diffi-
cult for some businesses to obtain bank finance.
This implies that future borrowers and lenders
may operate in a different financial environment
than currently exists.
Interest rate risk
Regulatory agencies are aware that exposure to
interest rate risk should be considered in bank
regulation. The Basel Committee has been debat-
ing this issue since the late 1980s, although no
formal proposals on this subject have been of-
fered to date. The Office of Thrift Supervision
proposed early in 1991 a model for incorporating
interest rate risk into thrift capital regulation. This
proposal was withdrawn pending action by other
U.S. bank regulatory agencies. Staff at the Federal
Reserve Board of Governors recently suggested a
system to measure the interest rate risk exposure
of banks, but not to impose a specific capital
charge for this risk. Instead, the measure would
be used by examiners to evaluate banks' risk
management policies and to suggest ways for
banks to reduce this risk exposure.
The banking reform bill recently signed into law
requires regulators to broaden the risk-based
capital standards in the next few years by consid-
ering additional elements of bank risk, including
interest rate risk. This raises an interesting policy
question: will unilateral action by U.S. bank reg-
ulators to stiffen capital standards further impair
the competitiveness of u.s. banks relative to for-
eign banks? The answer to this question could
be important for the future of the U.S. banking
system.
Jonathan A. Neuberger
Economist
References
Avery, Robert, and Allen Berger. 1991. "Risk-based
Capital and Deposit Insurance Reform./I Journal
of Banking and Finance 15, pp. 847-874.
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author.... Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.
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Index to Recent Issues of FRBSF Weekly Letter
DATE NUMBER TITLE AUTHOR
6/14
7/5
7119
7/26
8116
8/30
9/6
9/13
9/20
9127
10/4
10111
10118
10/25
1111
11 /8
11115
11/22
11/29
12/13
12120
1/3
91-24
91-25
91-26
91-27
91-28
91-29
91-30
91-31
91-32
91-33
91-34
91-35
91-36
91-37
91-38
91-39
91-40
91-41
91-42
91-43
91-44
92-01
Free Trade with Mexico?
Is the Prime Rate Too High?
Consumer Confidence and the Outlook for Consumer Spending
Real Estate Loan Problems in the West
Aerospace Downturn
Public Preferences and Inflation
Bank Branching and Portfolio Diversification
The Gulf War and the u.s. Economy
The Negative Effects of Lender Liability
M2 and the Business Cycle
International Output Comparisons
Is Banking Really Prone to Panics?
Deposit Insurance: Recapitalize or Reform?
Earnings Plummet at Western Banks
Bank Stock Risk and Return
The False Hope of the Narrow Bank
The Regional Concentration of Recessions
Real Wages in the 1980s
Solving the Mystery of High Credit Card Rates
The Independence of Central Banks
Taxpayer Risk in Mortgage Policy
The Problem of Weak Credit Markets
Moreno
Furlong
Throop
Zimmerman
Sherwood-Call
Walsh
Laderman/Schmidti
Zimmerman
Throop
Hermalin
Furlong/judd
Glick
Pozdena
Levonian
Zimmerman
Neuberger
Pozdena
Cromwell
Trehan
Pozdena
Kim
Martin/Pozdena
Parry
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Risk-based Capital and Deposit Insurance Reform./I

Risk-based capital standards and bank portfolios

http://www.frbsf.org/publications/economics/letter/1992/el92-02.pdf

Risk-based capital standards and bank portfolios

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