EU authorities have permitted commercial banks to implement a particularly aggressive form of risk-evaluation methodology, the result of which is the ability to claim a thick loss-absorption cushion and to attest that the EU banking system is stable and resilient. It isn't: cushions are as thin as before the Eurozone financial crisis.
This is laid out in the newly-released book 'The shadow liabilities of EU Member States, and the threat they pose to global financial stability', written by Bob Lyddon and published by The Bruges Group.
EU authorities have blessed an aggressive implementation of the Advanced Internal Ratings-Based methodology (or AIRB) through which banks evaluate the risk-of-loss on both their lending and other on-balance sheet business, and on their off-balance sheet business such as guarantees, foreign exchange and derivatives.
Each piece of business is subjected to a process of 'risk-weighting', both for its own characteristics and for the counterparty with whom it is conducted. The result is a so-called 'risk-weighted asset' (RWA), representing the risk contained in the piece of business. The RWA inevitably comes out as much smaller than the nominal amount: a mortgage loan of €200,000 will convert to an RWA of €20,000. The RWA of any piece of business conducted with an EU public sector entity will be even lower, because of the incorrect implementation of global rules on what constitutes a risk that merits a 0% risk-weighting. This subject was examined in an earlier book – 'Managing Euro Risk.
Once the RWA is ascertained, capital needs to be assigned against it, and the normal measure of capital is called Common Equity Tier 1 or CET1: it comprises shareholders equity and retained profits. Banks are obliged to have CET1 of between 8-10% of their RWAs, another diminution: the mortgage loan of €200,000 might require only €2,000 of CET1: 1% of the nominal.
The intention and effect of AIRB are to diminish RWAs to the extent that the bank's existing and fixed amount of CET1 exceeds the 8-10% threshold. EU banks have been unable to obtain new CET1 through the normal methods: issuance of new shares, making post-tax profits, or making business combinations that add value rather than being bailouts. Instead they have released a certain amount of capital from accounting trickery to do with the valuation and/or sale of bad loans, and have conjured up surplus capital via AIRB.
Monte dei Paschi di Siena is a case in point. It had accumulated a large amount of bad loans. The Italian state owns a majority and has been trying unsuccessfully to sell out. As at 31 March 2021 the bank had CET1 of €5.96 billion, when its nominal assets were €146.66 billion: 4%, or at best half of the CET1 it needed. However, its RWAs were shown on p. 59 as only €48.90 billion giving it a CET1 Ratio of 12%, a comfortable surplus. Risk-weighting diminished the bank's assets by 66%. The resulting CET1 ratio showed the bank to be in robust good health, so why was it unsaleable?
This is a systemic problem: CET1 Ratios across the EU banking industry show surpluses but this is entirely attributable to the EU authorities permitting AIRB and in the most aggressive manner possible. In reality loss-absorption cushions are wafer-thin, if they even exist at all.
