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Might banks cook their risk books in the heat of the moment?

Tiny adjustments on inputs can produce big benefits on capital ratios: the temptation to manipulate is obvious.

According to analysts at Barclays Capital, the average risk weighting that European banks apply to their assets when calculating regulatory capital ratios has declined steadily from 49% in 1998 to 35% at the end of 2010.

Although it might well be that banks have deliberately reoriented their exposures in recent years by shifting towards asset classes that consume less regulatory capital because they are less risky, it would be touchingly naive for any investor to draw too much comfort from this. That decline in average risk weightings was gathering speed, hitting 45% in 2005, just as banks accelerated into a brick wall of asset write-downs.

As the reduction in risk weightings as a percentage of total assets increases, so do suspicions that banks are cooking the books. Many bank executives are fearful that equity investors won’t supply the higher amounts of capital regulators now demand because their returns are so low. Lowering the risk weighting is a good way to make a capital ratio that comes out only just above the regulatory minimum suddenly appear well above the minimum. So while it is possible that low risk weightings are entirely justified, investors and regulators would be remiss if they did not ask for more explanation from banks that report a combination of both low RWA percentages of total assets and a high reliance on internal risk models to calculate these scores across their balance sheets.

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