Julia Irvine 25 Jan 2019 05:25pm

Banks' risk-weighted assets need assurance

ICAEW has renewed its call for independent scrutiny of banks’ capital ratios and risk-weighted assets after Metro Bank’s share price dived following the revelation that it had made mistakes in its calculations

The institute says that Metro Bank’s experience illustrates just how important risk-weighted assets (RWAs) are to understanding a bank’s strength and resilience. “Yet, unlike the financial statements, these crucial numbers are not currently required to be subject to any independent scrutiny,” it points out.

At the very least, says Philippa Kelly, head of financial services at ICAEW, the calculations should be subject to some sort of assurance, possibly by internal audit initially, although some institutions may want independent assurance. The review of the future of audit, which is being led by Sir Donald Brydon, could also consider the question of whether bank audits should be extended to cover them.

However, unless the Prudential Regulation Authority (PRA) made it a regulatory requirement, it would be “nigh on impossible” for the bank’s auditors to carry out the assurance because the additional costs would run up against the current cap on non-audit services.

Two days ago, Metro Bank revealed that it had miscalculated the risk weightings for certain commercial property and buy-to-let loans and that it would need to increase the total of its risk-weighted assets by £900m to £8.9bn.

The challenger bank’s shares immediately went into free fall on the back of investors’ concerns that they could be asked for more capital to shore it up. They plummeted 39% from £22 to £13.45 at the close of the day, wiping £800m off the bank’s value. They are currently trading at £14.32.

Kelly argues that some form of assurance would benefit both banks and investors. “The calculation of capital ratios and RWAs is complex,” she says. “It requires bringing together a large amount of information from disparate sources, using lots of judgment and skill – both mathematically and in risk assessment, and understanding economic conditions and customer behaviours.”

While the major banks have built their own business models using the internal rating based (IRB) approach, under the watchful eye of the PRA, smaller banks, like Metro Bank, may not have the resources or the expertise to do so. Instead they follow a standardised approach, established by the Basel Committee on Banking Supervision, into which they fit their assets.

Some of the smaller banks have become more confident about their ability to set up their own independent models since going through the process of implementing IFRS 9, Financial Instruments, Kelly said.

However, while IFRS 9 was “a leap in the right direction”, it does not give the complete picture on risk-weighting.

Two years ago, ICAEW created an assurance framework which helps give banks and their stakeholders more confidence in the figures. It was deliberately designed to be flexible so it could be used by both internal and external auditors.

Although the framework has been used from time to time, it has not gained widespread traction among banks whose focus has been on implementing IFRS 9 and other regulatory changes.

However, Kelly points out that if banks want the reassurance of an independent view on their risk-weighting controls and processes, and to help avoid a similar situation, they should look to adopting the assurance framework.

“Banks and their stakeholders need more confidence in the controls, processes and governance surrounding the calculation. For challenger banks seeking to offer alternatives in the retail banking sector, investor confidence is critical. Demonstrating their key metrics are reliable is vital.”

The PRA is currently undertaking a long-term project on the scope of assurance, looking at all the areas where it asks for assurance (or not) and whether this is applied consistently. Among the many things likely to be in its sights is the reason why it requires insurers to have their solvency and financial condition reports (SFCRs) audited but not banks’ Pillar 3 reports.

There is an argument that this is because a larger proportion of banks’ capital returns are based on audited accounts compared to SFCRs, hence the additional comfort required of insurers.

On the other hand, it could be argued that, since banks’ capital resources are based on audited numbers but their capital requirements (derived from RWAs) are not, both the capital requirements and RWAs should be audited as well.

However, since the scope of assurance project covers a huge amount of territory, the answers to this and other questions are unlikely to be forthcoming any time soon.