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Proposed changes to risk-weighting methodology

January 22, 2013
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Written by Shea Dittrich, Sageworks

Shea Dittrich

Regulators realized, with Basel and Dodd-Frank, that capital frameworks must include an understanding of the risks associated within each financial institution. But, in order for capital requirements to reflect risk appropriately, the institutions must have a sound way of measuring that risk, namely risk-weighting. The current methodology to determine risk-weighted assets is somewhat simple.

Presently, banks’ risk-weighting calculation categorizes assets into four risk-weighting categories: 0 percent, 20 percent, 50 percent, and 100 percent. A commercial loan, for example, is weighted at 100 percent. This weighting does not account for collateral, cash flow or character. Moreover, it does not account for the complexities that have surfaced over the past several years with cross-collateralization and multiple guarantors. Consequently, setting a regulatory capital requirement based on the existing risk-weighting calculation does not truly measure the different risk within each financial institution.

The FDIC, Federal Reserve and OCC are making efforts to create a new, standardized risk-weight approach to assets that is much more indicative of the potential risk that may exist within a financial institution. It applies more stringent weighting based on certain concentrations, and it requires that each bank implement new processes to determine the risk.

The following chart shows significant changes that would take place with the reform to the standardized risk-weighting approach. If banks were utilizing this method today or had to implement it immediately, it could be detrimental to their current capital situation:

 

Category Current Risk-Weight Proposal
1-4 Family  50% 35-200%
Commercial Real Estate 100% 150%
Past Due Exposures Does not change 150%
Corporate Exposures 100% 100%

 

 

For the 1-4 Family Loans, the proposed risk weight is dependent upon the loan to value (LTV) as well as the risk category of the loan. According to the FDIC, “The proposed definition of category 1 residential mortgage exposures would generally include traditional, first-lien, prudently underwritten mortgage loans. The proposed definition of category 2 residential mortgage exposures would generally include junior-liens and non-traditional mortgage products.” Category 1 benefits from a lower risk weight than category 2.

The proposed changes would also assign a new risk weight to exposures that are 90 days or more past due. Generally, with current risk-weighting rules, past due exposures did not change risk weights when the loan becomes past due. This does not hold for 1-4 family loans under the current system, which did increase to 100 percent risk when the loan reached 90 days past due.

Download the latest whitepaper, “Risk-Weighted Assets: 4 ‘Risky’ Questions Regulators Want You to Ask” to learn what the proposal is and how financial institutions can start to prepare.

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