Most major banks chose to use the so called advanced risk weighted approach to calculate the amount of capital they are required to hold as part of the Basel III frameworks against loans they write. This is an immensely complex (many would say over complex) and myopic approach to managing the risks in the banking system. But even then, who reviews and checks the approaches used, the calculations made and so the risk status of each bank?
Certainly the regulators do not have the time and resources to check each one in detail, so they tend to take the results on face value. So it was interesting to note that on 4 March, the secretary general of the Basel Committee on Banking Supervision (BCBS) suggested that entrusting external auditors with some responsibility for checking banks’ calculations of their risk-weighted assets (RWAs) would reduce the risk of errors and regulatory arbitrage.
External auditors would add another line of defense and enhance the accuracy and reliability of banks’ calculations of their Common Equity Tier 1 (CET1) ratios, a credit positive.
According to Moody’s, RWAs constitute the denominator of banks’ CET1 ratios and are commonly calculated by large banks themselves based on their own data. Because they are based on regulatory rather than accounting concepts, external auditors are not commonly entrusted with certifying whether banks’ calculations of RWAs are accurate.
RWA calculations are subject to the scrutiny of supervisors who have often expressed concerns about banks’ internal estimates of their RWAs. This lack of trust has led to many initiatives: in December 2017, the BCBS introduced input and output floors as a means to limit the benefit that banks can obtain from calculating model-based RWAs (the so-called Basel IV framework).
The input floors are minimum thresholds imposed on parameters used in internal models. The output floor adds an overlay of constraint whereby the maximum benefit from implementing internal models is limited to 72.5% of the calculation derived from the new standardized approach. However, this new framework will only apply starting in January 2022 and the output floor will be phased in through January 2027.
Along the same vein, the European Central Bank recently embarked on a multiyear endeavor aimed at checking the quality of banks’ internal models (referred to as targeted review on internals models, or TRIM) and instructed many banks to fix identified shortcomings which often resulted in additional RWAs.
Supervisors to some extent rely on auditors’ verification of financial statements to conduct their own prudential analysis. Beyond this, auditors vet banks’ internal credit risk models under International Financial Reporting Standard No. 9 (IFRS 9), and those models are closely linked to prudential capital models. External auditors already play a role in banks’ data and processes that are critical for the computation of RWAs.
Additionally, some supervisors already commission external auditors to undertake specific work as a means to complement and inform their supervisory work. Within the European Union, supervisors in an estimated 10 countries require external auditors to provide comfort on capital, solvency and other ratios.
However, the formal validation of RWAs and capital ratios remains outside the scope of the audit. There has been no official decision by the BCBS as to whether the relationship between supervisors and external auditors should be standardized. Entrusting external auditors with a mandatory responsibility to certify CET1 ratios in addition to their usual remit would be a bold step if this initiative were to be spearheaded by the BCBS in its role as global standard setter. It remains to be seen whether a sufficiently large consensus will emerge among BCBS members; some supervisors might be reluctant to empower external auditors with such a critical mandate.
To be sure, external auditors’ certification of CET1 ratios would not be a panacea. Calculating RWAs is a complicated process, particularly at banks that rely on risk-modelling techniques. External auditors are unlikely to be able to address all shortcomings that the supervisory community has wrestled with for years (e.g., accuracy and consistency of RWAs), even if the auditors’ involvement would add a useful line of defense to ensure the accuracy of RWAs.
