Capital Requirements vs. Model Restrictions: New Report Analysis

The Bank for International Settlements (BIS) reports that financial jurisdictions may face a choice between implementing higher capital requirements or imposing restrictions on internal modeling for banks. According to a report from the Financial Stability Institute (FSI), risk density and capital requirements maintain an inverse relationship, affecting how banks manage Common Equity Tier 1 (CET1) capital and risk-weighted assets (RWAs).

The findings center on the tension between the use of internal models to calculate risk and the resulting capital ratios. When banks use internal models to lower the risk weight of their assets, they reduce their RWAs, which mathematically increases their CET1 capital ratio. The FSI analysis indicates that this creates a dynamic where jurisdictions must decide if they prioritize the flexibility of these models or the stability of higher mandatory capital buffers.

This regulatory crossroads impacts global banking hubs including the United States, Canada, the United Kingdom, Switzerland, Japan, and China. These regions must balance the “Risk Quantum”—the absolute amount of risk a bank takes on—against the “Risk Density,” which is the risk per unit of exposure.

The FSI report notes that if a jurisdiction allows banks to continue using aggressive internal models to lower risk weights, those banks may appear better capitalized on paper while holding less actual capital relative to the true risk of their portfolios. To counter this, regulators can either restrict the models themselves or mandate a higher overall capital ratio to ensure a safety margin exists regardless of the model used.

The relationship between these metrics is critical for the calculation of the capital ratio, which is derived by dividing the bank’s CET1 capital by its RWAs. By reducing the denominator (RWAs) through internal model adjustments, a bank can maintain a high ratio without increasing its actual capital holdings.

The BIS and FSI’s focus on this inverse relationship suggests a move toward more standardized approaches to risk weighting. Standardized approaches provide a uniform set of weights for different asset classes, reducing the ability of individual banks to use proprietary models to lower their reported risk.

The implications for global banks are two-fold:

• Model Restrictions: Regulators may implement “output floors,” which prevent a bank’s internally modeled RWAs from falling below a certain percentage of the RWAs calculated under the standardized approach.
• Capital Hikes: If model flexibility is preserved, regulators may increase the minimum CET1 requirements to offset the potential underestimation of risk inherent in internal models.

These measures are part of a broader effort by the BIS to prevent systemic failures by ensuring that the capital held by banks in major economies accurately reflects the risk of their lending and investment activities. The FSI’s data suggests that without these interventions, the divergence between a bank’s perceived risk and its actual risk exposure could widen.