Risk sensitivity bites

We knew in the abstract this happens, but seeing it in the particular is chastening. From FT alphaville, discussing research from Credit Suisse:

Risk weighted assets and capital ratios under Basel I were relatively static. But that is unlikely to remain the case under the new variant. Risk weighted assets will move with the probability of default and the loss given default within a bank’s loan book. A required deduction for “expected losses” from capital will also mean more volatility.

The principles apply across a range of lending, corporate and unsecured, but it is the sensitivity of risk weighted assets to the UK housing market that has got Credit Suisse issuing this alert.

The note then goes on to look at HBOS. In what follows italics are the FT and bold is the FT quoting Credit Suisse.

The movements are significant. A 10% fall in house prices increases both the EL and mortgage risk weighted assets at HBOS by about 50% on our estimates. A 20% fall in prices more than doubles them.

In addition, RWA could also rise as older, lower LTV lending is replaced with new, higher LTV lending, they add, meaning an overall forecast for a rise of 60 per cent if house prices fall 10 per cent, in line with CS forecasts.

At a group level, this would lead to an increase in RWA of about 7%. Simply applying the increased EL and risk weight to the 2007 Basel II figures reduces the equity tier 1 ratio from 5.7% to 5.3%, on our estimates.

Ultimately Credit Suisse argues that the changes under Basel II mean that the market will start to react to movements in banks’ reported capital ratios. That, in their view, is the main threat to share prices, with the impact of an economic slowdown and house price slide on reported ratios becoming as important as that on profits in future earnings rounds.

Anti-cyclical capital ratios anyone?