Danish Banks’ Risk Weighting Methods Criticized

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A recent study has uncovered significant disparities in the way Danish and Faroese banks calculate their risk weights for corporate exposures. This article will delve into the findings of the study, exploring the differences in risk weighting methods and their impact on capital requirements, lending, and systemic risk.

Risk Weighting Methods: A Tale of Two Approaches

The study highlights significant differences in the way large Danish banks (using the IRB approach) and other Danish banks (using the Standardised Approach) calculate their risk weights. While institutions with IRB authorization have a larger share of loans to corporates, their risk weights are significantly lower compared to those employed by other Danish banks.

The disparity can be attributed to the fact that institutions with IRB authorization are often large and have a highly diversified portfolio with a loss history justifying the approval of low risk weights.
In contrast, Faroese banks have posted higher losses and impairment charges than their Danish counterparts since 1996, suggesting that their risk weights may not be as low if they were given IRB permission.

Capital Requirements and Lending

The study also explores the relationship between capital requirements and lending. While some argue that stricter capital requirements reduce lending and increase interest rates, the research suggests that this is not necessarily the case.

An increase in equity can make a bank more resilient to losses on assets, reducing the risk of creditors suffering losses.
Banks may adjust to higher capital requirements in various ways, including increasing their capital, reducing risk-weighted assets, or reducing excess capital adequacy.

The transition to Basel III in Denmark did not result in a decline in lending, suggesting that banks are able to adapt to changing capital requirements without significantly impacting their lending activities.

Faroese Banks’ Capital Requirements

The study also examines the capital buffer requirements and excess capital adequacy of Faroese banks. Despite an increase in buffer requirements, there has been no decline in lending in the Faroe Islands in recent years, which is attributed to the economic upswing in the region.

All four Faroese banks will be able to meet the phased-in buffer requirements and systemic risk buffer of 3% from January 2020.
The primary funding sources for Faroese banks are deposits and equity, with a significant share of deposits not covered by the deposit guarantee scheme. This makes them sensitive to risks in the banks.

SIFI Requirements

Systemically Important Financial Institutions (SIFIs) are subject to additional requirements designed to reduce the probability of failure and limit negative consequences if they do fail. SIFIs must comply with a SIFI capital buffer requirement, which is intended to ensure that these institutions have sufficient capital to absorb potential losses.

The study highlights the importance of ensuring that SIFIs maintain adequate capital levels to mitigate systemic risk and protect the economy from potential failures.

Conclusion

The study suggests that the way banks calculate their risk weights and respond to changing capital requirements can have significant implications for lending activities and economic stability. It is essential for regulators and policymakers to consider these findings when setting regulatory requirements, ensuring a stable and resilient financial system.