Regulatory capital issues

The Basel Capital Accord generally does not recognize differences in the credit quality
of bank assets for purposes of allocating risk-based capital requirements. Instead,
the Accord’s risk weights consider the type of obligation, or its issuer. Under current
capital rules, a ‘Aaa’ corporate loan and a ‘B’ rated corporate loan have the same risk
weight, thereby requiring banks to allocate the same amount of regulatory capital
for these instruments. This differentiation between regulatory capital requirements
and the perceived economic risk of a transaction has caused some banks to engage
in ‘regulatory capital arbitrage’ (RCA) strategies to reduce their risk-based capital
requirements. Though these strategies can reduce regulatory capital allocations,
they often do not materially reduce economic risks.

Risk weighted assets (RWA) are derived by assigning assets to one of the four
categories above. For example, a $100 commitment has no risk-based capital requirement
if it matures in less than one year, and a $4 capital charge ($100î50%î8%)
if greater than one year. If a bank makes a $100 loan to a private sector borrower
with a 100% risk weight, the capital requirement is $8 ($100î8%).
Under current capital rules, a bank incurs five times the capital requirement for a
‘Aaa’ rated corporate exposure (100% risk weight) than it does for a sub-investment
grade exposure to an OECD government (20% risk weight). Moreover, within the
100% risk weight category, regulatory capital requirements are independent of asset
quality. A sub-investment grade exposure and an investment grade exposure require
the same regulatory capital.

The current rules provide a regulatory incentive for banks to acquire exposure to
lower-rated borrowers, since the greater spreads available on such assets provide a
greater return on regulatory capital. When adjusted for risk, however, and after
providing the capital to support that risk, banks may not economically benefit from
acquiring lower quality exposures. Similarly, because of the low risk of high-quality
assets, risk-adjusted returns on these assets may be attractive. Consequently,
returns on regulatory and ‘economic’ capital can appear very different. Transactions
attractive under one approach may not be attractive under the other.

Banks should develop capital allocation models to assign capital based upon
economic risks incurred. Economic capital allocation models attempt to ensure that
a bank has sufficient capital to support its true risk profile, as opposed to the
necessarily simplistic Basel paradigm. Larger banks have implemented capital allocation
models, and generally try to manage their business based upon the economic
consequences of transactions. While such models generally measure risks more
accurately than the Basel paradigm, banks implementing the models often assign
an additional capital charge for transactions that incur regulatory capital charges
which exceed capital requirements based upon measured economic risk. These
additional charges reflect the reality of the cost imposed by higher regulatory capital
requirements.