That takes us to a third potential explanation for the downward trend in risk weights, one familiar from every other field of self-regulation – the system has been gamed or arbitraged (Blum (2008), Masera (2012)). Under a self-assessed standard, banks may have both the incentive and the ability to shade downwards risk weights, or to switch to lower risk-weighted asset categories, thereby boosting reported capital ratios. The aggregate evidence is consistent with this having occurred secularly and on a significant scale. Firm-specific evidence is also consistent with this hypothesis. A survey by McKinsey in 2012 found that 65% of firms were engaged in “RWA optimisation” of some form (Babel et al (2012)). And the recent US Senate investigation of the J P Morgan “whale” incident is the latest in a long line of identified misdemeanours sourced in model manipulation. In short, while one of the original aims of the Basel Accord was to prevent a race to the bottom, the move to risk-based capital adequacy standards may in fact have accelerated it. What, then, of the second objective of the original Basel Accord - levelling the international playing field? From an economic perspective, a level playing field would imply that banks with equivalent portfolios should hold a broadly equivalent amount of capital. The most compelling test of this hypothesis comes from the hypothetical portfolio exercises (HPE) recently conducted in the UK and internationally. These take a set of common portfolios and ask how much capital banks’ internal models would set against them.
The acid test of whether these empirical and theoretical concerns about risk-weighting have merit comes from assessing the evidence. Do risk weights help in signalling bank failure? There have been a number of recent studies comparing the predictive performance of Basel risk-based capital ratios and simple leverage ratios for bank failure. The results are both striking and surprising. Studies by IMF (2009), Demirguc-Kunt et al (2010), Haldane and Madouros (2012), Mayes and Stremmel (2012), Brealey et al (2011), Berger and Bouwman (2013), Blundell-Wignall and Roulet (2013) and Hogan et al (2013) perform a horse-race between different bank solvency measures, using a variety of techniques, samples and controls. Despite these differences, the conclusion they draw is broadly consistent: leverage ratios perform as well, and in most cases better, than risk-weighted alternatives in predicting bank failure. These results appear to be stronger for large banks, often using internal models, than for smaller banks typically using standardised approaches (Haldane and Madouros (2012)). This is not altogether surprising given that model risk is largest among banks making greatest use of models and with the largest portfolios. It is also the case that no measure of bank capital adequacy, by itself, provides a full-proof forecast of impending bank failure: the predictive power of all solvency metrics, leverage or otherwise, is fairly low. BIS central bankers’ speeches  5  Nonetheless, these results send a sobering message. Even on risk-sensitivity grounds, riskbased capital measures may often be trumped by risk-insensitive alternatives. The noise in risk weights may be drowning-out the signal.