As an article in last week's Financial Times notes (Time to work out real odds in the weighting game, May 2), some European regulators are calling for a standard way to calculate risk-weighted assets (RWA) under Basel. RWAs and equity are used to determine a bank's capital strength. Banks and countries have inconsistent calculation methodologies for RWA, causing concerns that accuracy is not uniform globally and may put some banks at risk of mismatching their tier 1 capital holdings when compared against the absolute risk in their portfolios.
Fluctuations in the economic cycle are notoriously hard to forecast, leading to lagged volatility in the RWA calculation regardless of methodology chosen. Predictive models measuring credit risk tend to capture and reflect the influence of the current cycle point – resulting in widely different RWA values for the same inherent risks. What these models should be doing is anticipating the future impacts of the economy on borrower repayment behaviors.
I discussed a solution to this approach in my recent Insights white paper Leaning Into the Next Economy: The Counter-Cyclical Imperative. Marrying credit scoring with economic forecasts can control model cyclicality, and produce more stable RWA measures based on the future, not the past.
We have worked with leading banks across Europe on solving these kind of Basel-related analytic issues. The approach that studies economic impact can be highly effective both in meeting regulatory demands and in making smarter risk and capital management decisions.