In 2011, JPMorgan Chase executives told its CIO to reduce risk-weight assets, which are used by regulators to assess a bank’s health and required capital levels. The CIO estimated that the bank could alter its risk models by reducing its risk-weighted assets by $7 billion without having to sell the securities, Fox Business reports.
The bank’s London-based CIO, however, went on to lose more than $6 billion last year from a number of bad derivatives bets that came to be known as the “London whale” trades, and a Senate investigation found that JPMorgan’s changes to its risk models contributed to the massive loss.
Investors say that, as many banks face more stringent capital requirements under Basel III rules, more institutions have considered changes to their risk models, including the implementation of elaborate algorithms used to measure risk and ensure adequate capitalization. Under Basel III rules, banks are permitted to reduce their risk-weighted assets if a model can prove the position is not risky, according to Fox Business.
Because capital remains a key element of soundness in the banking system, bad risk models can lead to undercapitalization, a problem that contributed to the recent financial crisis, and taxpayer-funded bailouts. Some banking industry participants say, however, that maintaining high capital levels makes financial institutions less profitable.
Experts on financial risk maintain that while banks may seek regulatory approval for new risk models, regulators may be unable to determine if the new models are adequate. One regulatory examiner said regulators require detailed information on new models and challenge the banks if the models are inadequate.
“We are going into their credit books all the time, literally pulling out securities and testing them on the models every quarter,” the examiner, who declined to be identified, said, Fox Business reports.
Recent stress tests from the U.S. Federal Reserve revealed that banks’ own capital calculations differed significantly from those of the central bank, leading Basel III regulators to consider alterations to the new capital requirements.
JPMorgan Chase plans to reduce its risk-weighted assets by $20 billion, while Goldman Sachs intends to cut its risk-weighted assets by $28 billion by the end of the year utilizing technology that allows traders to assess risk-weightings of individual securities more quickly. Goldman Sachs said late last year that without its model changes, Basel III rules would increase risk-weighted assets by 40 percent.
“Risk-weighted assets used to be done by some department of the bank and no one concentrated on them; they were insignificant,” consulting firm McKinsey & Co. said, according to Fox Business. “Now we’re all trying to optimize them.”