Capital Risk Weightings for Crash Test Dummies

Illustration to ring-a-ring-a-roses in Kate Greenaway’s Mother Goose, taken from the Project Gutenberg version project gutenberg: www.gutenberg.org/wiki/Main_Page in the public domain.


Children cling to their blankies and you cannot part them with the Disney printed fluffy blanket even when dirt, food and unspeakable things disguise Eeyore’s picture for all but the tail. Sometimes I think economists have a blanky relationship with reserve and fractional banking.

The fact is reserve banking hardly features in debt formation decisions. It was fundamentally and decisively replaced with a system of Capital Risk Weightings as introduced in Basel I and refined in Basel II. The Bank for International Settlements is very aware of risk in international settlements and the name of the money game has always been to receive settlement (or to get it back if you’ve lent it out). Capital Risk Weightings is a magnificent distributor of debt yet when you mention Basel II or Capital Risk Weightings, economists seems to prefer the blanky. The reality is that reserve requirements are so easy to meet, banks run out of capital long before they have problems with reserve requirements.

It can get complicated but let’s discover the basics of Capital Risk Weightings through Sarel’s Bucket-shop Bank Inc (SBBI for all your Debt needs).

I convince family and friends to hand over their savings say $100,000 and I issue ordinary shares of $1 to each of them (100,000 shares in total). Time to go shopping.

Office Furniture $30,000
Computer Equipment $60,000
Office equipment and Counters $20,000
Stocks of Consumables $10,000

Oops, I spent too much. No problem, I’ll just borrow $20,000 and I’m ready for business.

Here then is the Balance Sheet of:

Sarel’s Bucket-shop Bank Inc





Having only tier 1 capital is totally inefficient. I can get some tier 2 capital by issuing long term bonds (normally 5 years or longer) and I need an equal amount of tier 2 capital. So let’s go ahead and issue long term bonds for $100,000.

Now I need some Central Government Bonds and treasuries to manage my liquidity access so I buy $100,000’s worth of Government Bonds, which thankfully has a Capital Risk Weighting of 0% and have no impact on my qualifying capital. You noticed off cause that we could run an infinite Ring a Ring o’ Roses here borrowing from the Central Bank and lending to the Central Government with absolutely no limitations other than that dictated by the Central Bank. Until we all fall down, that is.

My new dressed up and ready to go Balance Sheet looks as follows:


Sarel’s Bucket-shop Bank Inc



We are now in the banking business. First question, how much can I lend out (we’ll worry about the liquidity a little later)? The Basel II Concordat would generally require a 4% tier 1 primary share capital requirement against the Capital Risk Weighting. (Allocations of Capital Risk Weightings may differ for different countries and split at 8% primary capital and 4% secondary for up to 12% total capital allocations but the calculation method will remain the same.) The tier 2/3 requirements can range from another 4% to 8% but let’s just work with 4% tier 1 and 4% tier 2.

Here is the Capital Risk Weightings table.


Data Source: Bank of International Settlements.

One more risk weighting which is important, Qualifying Residential Mortgage Bonds at 35%.

Now to answer the question, “How much can we lend out?” The math is not complicated.

1. AAA to AA : No limit - as much as we can get in liquidity.

2. A+ to A- : Step one is to calculate the capital co-efficient, easy 8% times 20% and it is equal to 1,6% (0.08*0.20). We have $200,000 in qualifying Capital so we just need to divide $200,000 by 1.6% to tell us that we can lend out = $12,500,000-00. That is a tidy sum of money. Let’s check the calculation. We need to hold 1.6% in qualifying capital against out lending activity. Thus $12,500,000-00 times 1.6% is equal to $200,000 and we’re all filled up with lending. Say we can lend out the money at 4% and get deposits at 2.5%; then we can make 1.5% gross profit on $12,500,000-00. That will give us $187,500-00 pa in gross profit for a Gross Return on Shareholders Capital of 187,5% ($187,500/$100,000).

3. The next best capital allocation lending to engage in would be Qualifying Residential Property. Here goes: 0.08*0.35 = 0.028 (2.8%). Now $200,000 divided by 0.028 = $7,142,857-14. We need to get a better profit margin than A+ to A- lending so let’s say we get deposits at 2.5% and do mortgage lending at 5.5%. That’s a 3% Gross profit margin for a gross profit of $214,285-71 (7,142,857-14*0.03) and Gross Return on Shareholder’s Capital of 214.29%. We can obviously now calculate at which level of lending rate we will prefer A+ to A- lending above Mortgage lending.

There is no need to continue the math as the principles have been demonstrated. Let’s say we’ve decided to concentrate on Mortgage Lending. We convince depositors to give us the $7,142,857-14 and we pay 2,5% interest pa. They have deposit insurance, no risk and should not have any problem to give us the money (not so?).

Our impromptu bank is a good little business at this stage.


Sarel’s Bucket-shop Bank Inc




We are certainly not maximising our efficient use of capital. Thus the next business decision is to do an Asset Backed Securitisation. We take $5,000,000 of mortgages, securitise them and sell them off to investors for an immediate $400,000 trading profit. Fantastic, we now have an additional $400,000 in tier 1 capital and we have also released precious capital held against $5mil mortgage bonds. Time to maximise business activity by lending everything we can to build a much bigger Residential Mortgage portfolio.

Say we use the $400,000 to buy Government Bonds again. We must issue another $400,000 to get tier 2 Capital, again we buy Government Bonds with it. I’ve done all the calculations and our bank now looks like this:


Sarel’s Bucket-shop Bank Inc



Can this be for real, you may ask? Certainly, it was exactly how the game was played for every turn of the asset cycle from portfolio, to securitisation, to sell off produced immediate executive bonuses and the tills were ringing, ka-ching.

We are now a bank with $36.7mil in assets and doing very well. Unfortunately we get a Global Financial Crisis. Liquidity is not a problem (access to liquidity is so easy we do not have to overly concern ourselves with any reserving requirements that the Central Bank may impose on us). We just securitise the $35.7mil Qualifying Mortgages and do repurchase agreements with the Central Bank. The real problems are:

1. We can no longer get deposits to grow.

2. We get bad debts exceeding our gross margin of 3%.

3. We basically have only $500,000 of capital for a 1.4% capital protection against the $35.7mil mortgage loans. In banking talk, we cannot survive more than 4.4% bad debts on a Gross basis (3%%+1.4% and it is a lot less on a net basis – we have to live and get our bonuses).

4. What are we going to do when house prices drop by 50% and “home owners” hand in their keys? Half of the 35.7mil is $17.9 mil against only $500,000 in capital. We have a serious collateral problem not only on our books but also in all the securitisations that we have sold off.

5. We are actually impossibly beyond redemption.


Sadly here is where Sarel’s Bucket-shop Bank Inc kicks the bucket (RIP).

I hope that this simplified essay on Basel II based debt allocation will convince more economists to study the Basel Accords for applied modern banking practices and the interaction with Central Banks. Combine Capital Risk Weightings, easy access to liquidity, deposit insurance (explicit or implied) and securitisation for a turbo charged debt distribution channel far superior to any text book description of fractional banking and reserve requirements.

The role of Central Banks in facilitating unlimited liquidity provision to the banking sector has permanently changed the banking landscape into debt driven activity with deposit taking having been relegated to an afterthought. The fixation of deposit driven banking theories simply no longer apply and it is time to retire the blanky.



Sarel Oberholster
BCom (Cum Laude) CAIB(SA)
14 February 2009

© Sarel Oberholster

Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .