Danger Warning: Banks Knowingly Underestimate their Risks

We shouldn’t worry about our economies anymore, the banks explain, the crisis is behind us and the solvability ratios have clearly gotten better. Banks like to tell us that the risks are under control and that their cash cushion is comfortable enough.

The problem is that this risk reduction assessment does not come only from a more virtuous attitude, but also in part from dissimulation. As a matter of fact, “according to certain analysts, banks have revised their risk models in order to reduce the amount of unencumbered funds required by underestimating their risks and estimating their assets at optimal value”. And where do you think we read this? In an obscure publication from some conspiracy theorists? Far from it, really: This comes from no less than the 84th annual report of the Bank for International Settlements (BIS), the “central bank of central banks”, in charge, notably, of determining the prudential norms for commercial banks in the world (Basel III).

The report goes on, thereafter, noting that “this phenomenon is perhaps one of the causes of the ongoing sub-rating of banks stock shares versus their unencumbered funds’ book value. This preoccupation has been exacerbated by the realisation that risk weighting for similar assets varied considerably from one bank to another (page 107)”. Market commentary indicates that investors are not buying this clear improvement in the banks’ situation and are shunning the shares of this sector.

The BIS report also stresses the blindness of banks toward sovereign debt, and especially the one of their own country: “For the most part, banks attribute zero-risk weight to over half of sovereign debt instruments they hold (page 108)”, which means that banks keep no liquidity in reserve to cover for more than half of the sovereign debt they own. I guess that what happened in Greece and Cyprus has already been forgotten... right? And which are the countries particularly concerned? The report tells us, “Banks attribute considerably lower risk weighting to their own country’s sovereign debt than do banks from other countries. This bias in favour of the country of origin is particularly pronounced in the case of Portuguese, Spanish and Irish banks and, at a lesser degree, of the French, British and Austrian banks”. We’d like to thank the BIS for all this information!

And, wouldn’t you know, last week, one right after the other, the main Austrian bank (Erste Bank) and the main Portuguese bank (Banco Espirito Santo) announced they were both facing some serious difficulties (problems tied to Romania for the former, an inheritance war and some accounting shenanigans for the latter) that drove their stock down and, worse, are causing systemic problems in their countries’ banking system. So if we understand clearly what is going on, we realise that banks have not really taken preventive measures against sudden changes in their environment, and that their gross underestimation of risk puts them in a fragile position, should anything unexpected happen. Even though this news is not comforting, we have to assess it very seriously because it stems from a particularly well informed organisation that, for once, is not using double-talk.