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Risk Weights and Capital Requirements in Banking: A Comparative Analysis
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IRB Risk Weights and Their Impact on Institutions
The Internal Ratings-Based (IRB) approach for calculating risk weights is used by large, diversified institutions with a good loss history. This approach typically results in lower risk weights compared to the Standardised Approach (SA). In Denmark, institutions with IRB authorization have lower risk weights than Faroese banks and other Danish SIFIs.
- Lower risk weights: IRB authorization leads to lower risk weights for large, diversified institutions.
- Comparison with Danish SIFIs: Faroese banks and other Danish SIFIs do not have the same level of IRB authorization as large, diversified institutions in Denmark.
Impairment Charges and Losses: A Comparative Analysis
Faroese banks have posted higher losses and impairment charges than Danish SIFIs since 1996, especially on corporate loans. This indicates that if given IRB permission, the Faroese banks’ risk weights would not be as low as those of the Danish SIFIs.
- Higher losses: Faroese banks have experienced higher losses and impairment charges compared to Danish SIFIs.
- IRB permission impact: If granted IRB permission, Faroese banks’ risk weights may not be as low as those of Danish SIFIs.
Capital Requirements and Lending
Higher capital requirements can affect a bank’s ability to lend but do not necessarily reduce lending. Empirical evidence suggests that well-capitalized institutions are met with lower interest rates on debt and a lower required rate of return on equity.
- Capital requirements impact: Higher capital requirements may not directly reduce lending, but rather influence the terms under which loans are granted.
- Well-capitalized institutions: Well-capitalized banks are often met with more favorable borrowing conditions.
Excess Capital Adequacy in Faroese Banks
Despite an increase in buffer requirements, there have been no signs of a decline in lending in the Faroe Islands. The Faroese banks’ primary funding sources are deposits and equity, with a share of 45% of bank deposits not covered by the deposit guarantee.
- No decline in lending: Despite increased buffer requirements, lending has continued to grow in the Faroe Islands.
- Funding sources: Faroese banks rely heavily on deposits and equity for funding.
SIFI Requirements
Systemically Important Financial Institutions (SIFIs) are subject to additional requirements to reduce the probability of failure and limit negative consequences in case of their failure. These requirements include a SIFI capital buffer requirement.
- SIFI designation: Banks with significant systemic importance may be designated as SIFIs.
- Additional requirements: SIFIs must meet stricter capital requirements, among other conditions, to mitigate potential risks.