The Financial Services Authority has been assessing how lenders calculate the riskiness of their mortgages and other loans to make sure they are setting aside enough money to cover potential losses.
The FSA has stepped up that scrutiny in the past two months, banking sources said, as part of a wider trend in Europe towards standardising guidelines on how banks should calculate the riskiness of loans amid concern some are gaming their internal models to flatter their financial health.
The issue is controversial. A large jump in capital requirements for the likes of Barclays , HSBC , Lloyds , and Royal Bank of Scotland , could further choke off the supply of credit, hurting the economy.
"(Standardised risk weights) is a blunt tool but it gives you consistency across the banks," a senior official at a top British bank said, adding the flip side was that the blunter it was, the more banks with better risk management get punished.
Lenders are under huge pressure to have higher capital ratios as new global rules, known as Basel III, are phased in this year to prevent a repeat of the 2007-09 financial crisis.
To meet the new rules, lenders are cutting their risk-weighted assets (RWAs) through disposals, by cutting risky businesses, and hedging. They are also tinkering with their internal models to make their holdings appear less risky, undermining the credibility of Basel III.
"The Basel rules stand or fall by the RWA calculations. If there are questions on how banks calculate their RWAs, the right amount of capital is almost a moot point if you cannot trust the denominator," said Mike Harrison, an analyst at Barclays.
"Investors are just uncomfortable with the risk weightings," he said. "It is difficult to find a smoking gun that shows banks are gaming the system. But there is an absence of proof that they are not."
Deutsche Bank said last month changes to its model had helped cut RWAs by 55 billion euros in the fourth quarter, boosting its capital ratio. Finance chief Stefan Krause defended the changes, saying the German lender's models would hold up amid moves to harmonize RWAs globally.
Both Basel regulators and the Bank of England say banks have shown wide variance in assessing risk in a sample portfolio of assets. The most prudent British banks estimated they needed more than three times as much capital as the most aggressive banks for the same assets, the BoE said.
The Bank of England has estimated the capital shortfall for Barclays, HSBC, Lloyds and RBS could be as much as 35 billion pounds if weightings were standardised.
Barclays last week increased its RWAs by 20 billion pounds to reflect methodology changes, effectively meaning it needs to hold 2 billion pounds more capital. It was allowed to increase its dividend, however, which analysts said showed the FSA was comfortable with its capital strength.
State-backed lenders Lloyds and RBS could be most affected by the stricter rules as they have thinner capital cushions than rivals and the large size of their loan books means even small changes in risk weightings can have a significant impact, several bankers and analysts said.
RBS said last year stricter rules will add 50-65 billion pounds to its RWAs by the end of 2013. Banks were expected to give more detail of the impact in results in the next two weeks.
The results will include the impact of a change in October, when the FSA told banks to increase their estimates of possible losses on British, U.S. and other government bonds.
That bumped up risk weightings on sovereign debt by about a third, bankers said, at a time when banks were being told to hold these assets as extra liquidity.
A DELICATE ISSUE
The Bank of England's Financial Policy Committee (FPC), which looks out for trouble spots in the financial system, said in November the way that banks calculated RWAs was too "complex and opaque" and needed fixing. The FSA was told to assess the problem and report back for a March 19 FPC meeting.
The FSA had already forced banks to attach a higher risk to corporate loans and government bonds, meaning they have to set aside more capital to cover potential losses. It is also assessing mortgages, mirroring a more conservative approach being taken in Sweden and Switzerland.
The FSA was not expected to go as far in standardising residential mortgages risk as it went with commercial loans, but one option is to set a minimum level, as Sweden has done.
The FSA, like other national regulators, has been approving large banks' internal risk model for years, but only in the past 18 months did it acquire specialist teams to better question models, a senior industry source said.
The FSA's most significant change has been to standardise the way commercial real estate loans are assessed.
Known as "slotting", loans are put in one of four categories and given the same risk weighting across all lenders. It means banks must hold billions more capital, which is being phased in and due to be fully in place by the end of this year.
It is unclear how far and fast the next phase of change will be. Andrew Bailey, the regulator overseeing the assessment, said last week it was "a delicate issue".
A senior executive at a British bank said there was significant danger in imposing standardised weightings and ignoring historical models and differences across banks in their risk management skills, how losses are defined and their attitudes to collecting losses.
"Abandoning a risk sensitive approach to the capital held against a given asset in favour of a more standardised approach would actually introduce more risk into the financial system."
The discrepancy in banks' models and the lack of transparency are deterring investors - more than 60 percent of investors surveyed by Barclays analysts last year said they had lost confidence in RWAs.
To help address those concerns, some of the biggest banks have agreed to give more detail on how their RWAs are calculated, under an initiative launched by the Financial Stability Board.
(Editing by Carmel Crimmins and Dan Lalor)