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Risk Management

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New Measures to Lift Veil on Banks' Capital Ratios

The game may soon be up for banks that have made themselves look healthier by understating how risky their businesses are, which should help pension funds, savers and companies to decide which institutions to invest in.

The game may soon be up for banks that have made themselves look healthier by understating how risky their businesses are, which should help pension funds, savers and companies to decide which institutions to invest in.

Bowing to pressure from regulators and investors, some of the world's biggest banks will soon implement a landmark initiative that promises to reveal far more detail on how banks calculate how much capital they need to guard against potential future losses.

It's designed to restore faith in the capital ratios that are the global benchmark for banks' financial health, ratios that are highly sensitive to banks' risk judgments since they are determined as a percentage of banks' own measure of assets as weighted by risk.

"We're expecting a lot of good disclosure from the banks, and where it's not happening we're expecting institutional investors to challenge management on why they're not doing so," said Russell Picot, chief accounting officer at bank HSBC and co-chair of the industry taskforce that came up with the new standards for what banks should tell investors.

The initiative was instigated by global financial rules setter the Financial Stability Board (FSB).

A study by the Basel Committee last week showed precisely why it is necessary, revealing that the most aggressive banks assign just one eighth of the risk weighting applied by their most conservative competitors, making their capital position appear far more robust.

Deutsche Bank came under fire on Thursday when it told investors that it managed a better-than-expected improvement to its capital ratio in the fourth quarter, despite losing 2.5 billion euros ($3.4 billion), largely by changing its approach to risk-weighted assets (RWAs).

EXPERTS IN THE DARK

Even analysts who specialise in banks' finances are unable to unravel the figures and work out which banks are really the healthiest or making the most progress, because of inadequate disclosure.

The new measures, which have been publicly endorsed by industry giants including HSBC, Deutsche Bank and Santander , will reveal key insights on the RWAs that feed into the banks' capital calculations.

Newly available information will include how much of their RWA improvements come from "optimisation", or model changes such as Deutsche Bank revealed last week.

"There may be a bank that is neither well capitalised nor liquid, and they may feel concerned that by publishing in greater detail, it will become even more obvious," Picot said.

"The message for them has to be that the market is pretty good right now at understanding banks' shortcomings."

Some banks will show their hands in the 2012 annual reports they will publish in the coming weeks. Stragglers are expected to follow suit later in the year as the transparency drive intensifies.

The capital disclosure measures are part of a broader suite of reporting enhancements devised by a taskforce of the world's biggest banks, money managers, research houses and accountancy firms to address concerns about banks' often opaque accounting.

The initiative Picot co-chaired began on a wintry day in Basel in December 2011, when 82 senior executives convened for what one attendee described as a "frank" round-table debate on how banks could improve the way they report their results.

INVESTOR CONFIDENCE

The FSB, headed by the Bank of England's incoming Governor Mark Carney, wanted to restore investor confidence in banks rocked by the market turmoil that began in 2008 and has yet to abate.

"The FSB felt that certain risk information was needed by participants right now," said Gerald Edwards, a senior official with the U.S. Federal Reserve Board who was closely involved with the taskforce while on secondment to the FSB in 2011.

The taskforce executives, drawn from global leaders including BlackRock, BNP Paribas, Allianz, Ernst & Young, Fitch Ratings, JP Morgan, Royal Bank of Canada, Santander and KPMG, began work in earnest in May 2012 and were given until October to finish.

Such was the intensity of the job that HSBC's Picot said he had two of his bank's staff working on it full time and recalls getting emails at midnight on a Sunday from one of the taskforce's subgroups.

With the task completed in a fraction of the time formal regulation would have taken, the focus is now on implementation.

Picot said there was no set target for take-up, but he expected to see some banks incorporate the new measures in their 2012 annual reports.

"We would hope that in a particular country, a bank that adopts this report and adopts it well will reset the level of what is considered good disclosure, and that other banks would adopt similar practices, and from that, the tide would rise," he added.

Regulators across the globe, who had extensive engagement with the taskforce, are also keenly following progress and will be encouraging their banks to opt in, according to Picot and Edwards.

Those who don't, may end up having to give more information anyway. "Some of this will be picked up and put into regulations," said Edwards.

DOUBTS REMAIN

The effort does have its doubters, including Dierk Brandenburg, banking analyst with Fidelity Worldwide Investments.

"We remain sceptical that banks across a wide variety of jurisdictions (Europe, U.S. and Asia) and accounting regimes ... are in a position to meet the requirements," he said, adding that the increased links between governments and rescued banks could "put a limit to what authorities may deem to be the appropriate level of disclosure to investors".

Crispin Southgate, a taskforce member and director of Institutional Investment Advisors, has high hopes for banks' voluntary adoption, nonetheless.

Banks were consulted and were "very responsive", he said.

"This report is setting a marker for some very high standards, which we hope banks will reach for ... We don't want banks to wait for new rules."

Copyright 2010 by Reuters. All rights reserved.

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