Meet the Author

William Bednar |

Senior Research Analyst

William Bednar

William Bednar is a senior research analyst in the Research Department of the Federal Reserve Bank of Cleveland. His work primarily focuses on banking and financial markets, macroeconomics, and monetary policy.

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Meet the Author

Mahmoud Elamin |

Research Economist

Mahmoud Elamin

Mahmoud Elamin is a research economist in the Research Department. He is primarily interested in applied theory, game theory, financial economics, and banking. His current work focuses on credit rating agencies, reputation, and regulation.

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01.08.13

Economic Trends

The Changing Composition of Bank-Holding Company Portfolios

William Bednar and Mahmoud Elamin

One test of the health of the banking sector is to evaluate how risky the assets in banks’ portfolios are. Regulators typically do this by considering banks’ risk-weighted assets. Here we will look at bank riskiness through the lens of the current regulatory system, where assets are risk-weighted according to a preset procedure established by regulators. We use a simple ratio—the ratio of a bank’s risk-weighted assets to its total assets—as a proxy for the riskiness of the bank’s portfolio. We analyze this ratio for bank holding companies (BHCs) over the past decade and find that BHCs have been reducing their risk-weighted  assets since the financial crisis by changing the composition of their asset holdings. At least part of this trend may be explained by banks trying to get in line with Basel III liquidity requirements, which are expected to come into effect soon.

We divide BHCs with assets above $500 million into three categories according to their asset size. A bank falls either in the top first percentile in terms of asset size, between the second and 50th percentile, or in the lower 50th percentile.

Risk-weighted assets are calculated by dividing each bank’s assets into four categories according to their level of risk, then multiplying the value of assets in each category by a risk weight and summing all the categories. The four risk weights are 0 percent, 20 percent, 50 percent, and 100 percent, with the highest weight being applied to the riskiest assets.

The 0 percent risk-weight category mainly includes cash, direct claims guaranteed by central governments of OECD countries and U.S. government agencies (including GNMA securities), and claims collateralized by cash or OECD government securities with a margin. The 20 percent risk-weight category includes cash items in the process of collection, short-term claims guaranteed by U.S. and foreign banks, long-term claims guaranteed by U.S. and OECD banks, claims guaranteed by U.S. states and OECD political subdivisions, claims guaranteed by U.S. government-sponsored agencies (FHLMC, FNMA, SLMA and others), and an array of repo transactions.

The 50 percent risk-weight category includes loans fully secured by first liens on one- to four-family residential properties or on multifamily residential properties, privately issued mortgage-backed securities (MBS) that satisfy some criteria, revenue bonds from U.S. states or OECD political subdivisions, and the credit amount of derivative contracts.

The 100 percent risk-weight category includes all assets not in the other categories. Also, off-balance sheet assets are treated by a two-step process. First, the “credit equivalent amount” of the item is computed, usually by multiplying the item by a credit conversion factor. Second, the resulting amount is treated as a usual asset.

The average ratio of risk-weighted assets to total assets for the largest BHCs (top 1 percent) has been declining for the last decade. The decline deepened during the crisis, but it appears to be leveling off since then, albeit with strong fluctuations. Medium-sized and small BHCs experienced similar trends; their ratios climbed until the crisis when they peaked, after which they fell off and only lately have begun to steady.

For the big BHCs, the composition of the riskiest assets (100 percent risk weight) in their portfolios has been declining for almost all of the decade, and steadying since the crisis. The 20 percent risk-weight category was on a slight upward trend up to the crisis where it peaked, after which it experienced a slight decline and a recent leveling off. The 50 percent risk-weight category has been declining slightly over the whole decade, with the crisis having no strong effect on the trend.  We also see an increase in the percentage of the least risky asset (0 percent risk weight).  This analysis shows that banks are increasing their exposures to assets with low risk weights (0 percent and 20 percent) and decreasing their exposure to assets with high risk weights (50 percent and 100 percent). This is particularly strong for the riskiest and the least risky asset.

For the medium-sized BHCs, the composition of the riskiest assets (100 percent risk weight) in their portfolios declined slightly after the crisis. The crisis seems to have caused these banks to substitute the least risky assets for the riskiest assets. This is not as pronounced as for the biggest BHCs though. The middle two risk-weighted categories remain at almost the same level with no clear trend.

For the smallest BHCs, the composition of the riskiest assets (100 percent risk weight) in their portfolios grew up to and peaked during the crisis. It declined significantly after the crisis. Again we see that the crisis seems to have caused a significant increase in the percentage of the least-risky asset (0 percent risk weight). This is interesting because it shows that the smallest BHCs are also substituting the least risky assets for the riskiest assets. The remaining two risk-weighted categories remain at almost the same level with no clear trend.

The conclusion we draw from this analysis is that all BHCs appear to be substituting 0 percent risk-weighted assets for 100 percent risk-weighted assets in their portfolios. This trend, though true for all sizes of BHCs, is strongest for the largest.