European banks are about to indulge in some sleight of hand. Though they have been told by regulators to raise 106 billion euros of capital by next summer, that doesn't mean they will issue that amount of new equity. Lenders are also planning to fiddle with the way they calculate risk-weighted assets (RWAs). They may end up shooting themselves in the foot.
There are three straightforward ways for banks to boost their capital ratios. They can issue equity - but valuations are low and investors wary. They can decide to not renew loans when they mature - but this takes time. And they can sell assets, but this may trigger losses, which could be counter-productive.
There is another approach, however. This is where banks hang onto their assets, but change the way in which they calculate the associated risks. This process is euphemistically known as "RWA optimisation". When banks make loans, regulators demand that they set aside a certain amount of capital. But different classes of loans carry differing risks. That is why assets are risk-weighted before calculating capital ratios.
Calculating RWAs is far from straightforward, however. Most small and medium-sized lenders use the so-called "standardised" methodology developed by the Basel Committee and policed by national regulators. A bank's assets are divided into separate pools and weighted according to their perceived riskiness. These pools are fairly crude: all residential mortgages, for example, carry a 35 percent risk-weighting regardless of quality.
Big banks tend to use a more sophisticated option called the "internal ratings-based" (IRB) approach. In this case, risk-weightings are based on banks' own analysis of the past performance of their loan portfolios. For each set of loans, banks estimate a probability of default (PD) and how much of the loan will be written off if it goes bad - the loss given default (LGD). These figures are then used to calculate risk-weighted assets. There are two varieties: "advanced" IRB, where the bank supplies both its PD and LGD, and "foundation" IRB, where the LGD is sourced from a set regulatory scale.
Switching from the standardised method to the IRB approach isn't easy: a bank must assemble a large risk team and get the regulator's blessing. But the move can pay off. For example, if a bank can show that its mortgage loans have a lower-than-average probability of default, switching to IRB could shrink its risk-weighted assets - thereby boosting its capital ratio. Italian lender Banco Popolare could boost its core Tier 1 ratio by as much as 100 basis points by switching from the standardised model to IRB, according to a person familiar with the situation.