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With the goal of improving the banking sector’s ability to absorb shocks from financial and economic stress, the new regulatory framework introduced after the recent financial crisis will increase the level and quality of capital ratios for the banking system.
This calls for accurate risk measurement that allows proper comparison across institutions and geographies, giving new importance to the consistency of underlying risk-weighted assets (RWAs).
With the expected transition of the US financial system toward Basel II and Basel III, which has revealed substantial divergences in the ratio of RWAs versus total assets between the United States and Europe, there is a new importance of RWAs across Europe. Accenture finds internal ratings-based (IRB) models falling short in treating risk across different countries and calls for prudent risk management for safeguarding financial stability with a consistent framework for RWAs that avoids undue distortions in their assessment.
Empirical evidence has made it clear that significant divergences exist in RWA density across banks—not only between the United States and Europe, but also within Europe. Accenture has identified that these differences exist on account of the following key determinants of RWAs:
Financial institutions having different risk profiles—on the basis of business model, macro and institutional factors.
Differences in the approach to risk management—including all decisions adopted by banks around risk monitoring, recovery practices and modeling choices.
Differences in supervisory practices—including different criteria for cycle adjustment, acceptance of IRB models, the definition of downturn and segmentation of portfolios.
To regain trust in risk weightings, the banking industry is looking at either “hard” solutions, like abandoning IRB and moving to the standardized approach or promoting the use of the leverage ratio, or “soft” solutions that include peer group or global regulator reviews, introducing or increasing minimum floors, or improving disclosures on through-the-cycle durations of default calculations.
Whatever solution the industry agrees on, banks stand to gain by implementing a new framework that can enable continued focus on RWAs. The proposed framework should include better understanding of the dynamics and drivers; internal and external reporting capabilities; full integration into the annual planning process; frameworks to monitor the evolution of RWAs on an ongoing basis; forecasting and simulating processes; and support from robust analytical capabilities.
Accenture has explored and analyzed three main points for a new framework with a continued focus on RWAs:
The empirical evidence on the evolution and current developments of RWAs: According to the Basel Committee for Banking Supervision, and the industry best practice principle for risk management, accurate risk valuation requires all different business lines and products within a bank to be qualified in terms of their level of risk. This is especially true under the Basel II agreement. Against this background, RWAs could be analyzed in time and cross-sectional dimensions.
The key determinants of RWAs: Not an easy task, Accenture classifies them according to three different groups of factors: bank risk profile, risk management and supervisory practices in different jurisdictions, which are crucial for banks using IRB models. These factors lead to justifiable divergences in RWAs and need to be analyzed for the extent of adjustment to avoid distortions in the assessment of risk weights.
The steps to regain trust in risk weightings: Divergences in RWAs are to some extent justifiable due to different risk profiles and risk management. But that is hardly the end of the matter. Gauging the appropriate magnitude of these divergences at an international level will take time and require a more complex analytical framework. Quantifying these factors will require detailed and comparable information from different financial institutions and jurisdictions.
Read this report for more details about the way Accenture analyzed the empirical evidence of RWAs and identified key determinants that can help define RWAs satisfactorily.
There is a clear need for a consistent framework for RWAs as we move into an environment of stringent requirements, accurate comparison of capital ratios and aggressive competition for capital. Since consistency of RWAs focuses on the use of IRB models, due to insufficient evidence, they should not be cast as the scapegoat for shortcomings in assessing RWAs.
In light of the financial crisis, Accenture clearly articulates the need for proper risk valuation as prudent risk management can play a significant role in safeguarding financial stability. Accenture recommends a consistent framework for RWAs and avoiding undue distortions in their assessment to contribute to that goal.
Read how Accenture’s deep and broad capabilities in risk models, scenario-based modeling, and risk architecture and data management can help banks manage their RWAs effectively.
July 5, 2012
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