Britain's banks could need up to 22 billion pounds more capital if regulators follow through with threats to change the risk weightings they apply to mortgages in assessing the size of their loan books, analysts have estimated.
Morgan Stanley analysts said they expect banks to be told to increase the risk weightings they apply on loans, which could require them to hold between 10 billion and 22 billion pounds of extra capital. Lloyds Banking Group would be hardest hit, they said.
Britain's Financial Policy Committee (FPC) last week said the potential for banks to assign different risk weights was "a matter of concern" that it would monitor. A week earlier, the UK Treasury said the FPC should have the power to require banks to hold more capital if it is worried about mortgage exposures.
The FPC, charged with spotting broad threats to market stability, is not alone in looking at risk weightings.
Banks have to set aside capital to hold against all loans in case they are not repaid, with their core capital adequacy or solvency ratio measuring the amount of core capital held as a percentage of its loans, or assets, which are valued according to risk. The riskier a loan is, the higher the value it is given in measuring a bank's risk-weighted asset (RWA) base, but the risk weighting applied to each type of loan can differ from bank to bank.
U.S. banks have long accused their European rivals of "optimising" risk weights to push down how much capital they need to hold, and this week the Basel Committee of the world's banking regulators slammed Europe's failure to apply rules properly.
Big banks are allowed to use their own models to assess how risky a mortgage or other loan is, under the internal ratings based (IRB) approach. It is based on banks' own analysis of the past performance of their loan portfolios, and has to be approved by regulators.
But that allows them to apply some low risk weightings. Lloyds, for example, applies an average risk weight of 16 percent for mortgages, but that includes an average risk weight of 2.2 percent for 143 billion pounds of high quality loans, Morgan Stanley said.
That means the bank applies a risk-weighted asset value of only 3.15 billion pounds to those mortgages, so it only needs to hold 315 million pounds of core capital to cover the 143 billion-pound loan book, implying a leverage of over 450 times.
Barclays, HSBC and Royal Bank of Scotland could also be affected and the RWAs of UK banks could increase by up to 221 billion pounds, or 8 percent, the Morgan Stanley analysts estimated.
Regulators recognise it is a tricky problem, however. If new risk weights are implemented too quickly banks could slash lending and choke off economic recovery.
"Regulators need to strike a balance between raising banks' capital levels and not stifling economic recovery," the Morgan Stanley report said.
(Editing by Greg Mahlich)