Banks’ average risk weight (risk-weighted assets per unit of assets) has almost halved, falling from over 70% in 1993 to below 40% at end 2011 (see, also, Blundell-Wignall and Atkinson (2011)). There are three possible interpretations of this trend. One is that banks’ assets, in aggregate, are around half as risky today as they were 20 years ago. A second is that banks are twice as good at managing these risks as they were 20 years ago. In the light of the crisis, which unearthed huge risks on banks’ balance sheets accumulated over this period, neither proposition rings especially true. To see why, consider the evolution of an alternative measure of risk – simple bank leverage. In the pre-crisis boom, bank leverage rose steadily to reach historically unprecedented levels. This signalled high and rising bank risk (Chart 2). Indeed, bank leverage and bank risk weights moved in opposite directions over this period, with a correlation coefficient of minus 0.6. While the risk traffic lights were flashing bright red for leverage, for risk weights they were signalling ever-deeper green. 2  BIS central bankers’ speeches  The subsequent financial crisis has made clear which traffic light signal was at fault.1 The boom was leverage-fuelled and so too has been the subsequent bust. At least at an aggregate level, bank risk weights appear to have borne, at best, a tenuous relationship with risk. At worst, they were a contrarian indicator.
As an example, take lending to the real economy – for example, to finance infrastructure, SMEs or trade. These asset choices are likely to be positive for medium-term growth and hence, indirectly, for credit risk in the financial system. In other words, this portfolio allocation is likely to deliver positive externalities for the wider economy. By contrast, lending within the financial system may have the opposite effect. It raises interconnectivity in the system, thereby amplifying systemic risk (Haldane (2009)). In other words, this portfolio choice may drive negative externalities for the financial system and wider economy. In an ideal world, these risk externalities would be taken into account in the setting of risk weights – for example, by raising risk weights on intra-financial system lending and lowering it on growth-positive lending. In practice, there is scant evidence of this having happened. Indeed, if anything the current risk-weighting system appears to generate the opposite set of incentives. Chart 7 looks at the average risk weight assigned by UK banks to different counter-parties, some in the financial system, others in the wider economy. The differences are stark. Mortgage risk weights are double those on lending to financial institutions. For large companies, risk weights are treble those on lending within the financial system. For SMEs, they are quadruple. Those are probably not the risk weights a benevolent dictator, charged with supporting the economy and armed with a PhD in welfare economics, would choose.