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In Focus Risk

Keep risk measurement within RWA refinements

Risk-weighted assets: retaining internal models without the comparability issues via hypothetical portfolio exercises

Paul Harrald Visiting professor in computing science, University College London

Refinements to risk-weighted assets (RWA) in the face of the recent polemic on internal models are in danger of eschewing risk measurement – which is, at worst, perverse. Are there ways to retain risk measurement

within RWA? Let us take a look at two hypothetical portfolios. If bank A and bank B own exactly the

same collection of corporate bonds – in all respects identical – then the capital requirement for those assets – the RWA – should be exactly the same for bank A and bank B, right? The well-known BCBS258 makes this assertion, for example. But it is wrong. Wrong, but very interesting. Here are four ‘risk management’ reasons

why the capital requirement should not be the same – the last three apply to RWA as well: l Those assets sit within a larger portfolio, and that portfolio will differ in its degree of correlation with the securities in question. l Those securities belong to a broad asset class, and, within that general class, one bank may be better at identifying the good from the bad – this implies internal ratings- based (IRB) models should give different answers. l One bank may be much more active in its portfolio management, for example it may dispose of bonds in a very conservative manner. l One bank may be more skilled or better informed in disposing of securities prior to failure of the issuer.


We can retain the risk- sensitive IRB framework. What we need to do is to hold the statistical methods constant and allow the data to differ by firm

l Differences in data and models – where the emphasis has been. l Difference in risk-management appetite and prowess – where the emphasis decidedly has not been. Note that the second of these implies the

models in the first should differ between banks, and hence so should internally- modelled RWA. Does this not suggest that hypothetical

portfolios are the one thing we need to add to disclosure? And, if bank A has less RWA than bank B for the same assets, then it must be true that bank A has models which perform better as a common rank ordering benchmark than bank B’s models. How revealing! But, much more. We can retain the risk-

Each of these reasons:

l Cannot be reflected in the current RWA regime – credit RWA cannot, by design, reflect changes in geographic or other forms of diversification. Credit RWA, in this regard is not fit for purpose. l Should be reflected in the default data of the bank, and hence its IRB models. l Reflects risk appetite and could be verified by internal data. The consequence here is that the

difference in internally-modelled RWA can be attributed to two main causes, whereas differences in true capital requirement require a consideration of diversification:

sensitive IRB framework. What we need to do is to hold the statistical methods constant and allow the data to differ by firm. In this way, we introduce no new definitional problems, reduce all the unnecessary variation in RWA that can be attributed to variations in modelling practice, and, using hypothetical portfolio exercises, reveal a great deal about risk appetite and risk- management capability. Moreover, none of the incentives to

develop internal non-regulatory models are eroded; indeed the incentive to generate good risk-management outcomes is enhanced. This, I believe, is the true way to resolve

the problems posed by the internal modelling approaches to RWA. CCR

October 2015

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