Last checked at 
* UK tells banks to take more conservative view of loan risk
* Bankers see risk to economy and models fromstandardisation
By Steve Slater
LONDON, Feb 25 (Reuters) - Britain's banks could need tensof billions of pounds more capital as part of a crackdown oninternal risk models that are deterring investors andundermining efforts to shield the global financial system fromfuture shocks.
The Financial Services Authority has been assessing howlenders calculate the riskiness of their mortgages and otherloans to make sure they are setting aside enough money to coverpotential losses.
The FSA has stepped up that scrutiny in the past two months,banking sources said, as part of a wider trend in Europe towardsstandardising guidelines on how banks should calculate theriskiness of loans amid concern some are gaming their internalmodels to flatter their financial health.
The issue is controversial. A large jump in capitalrequirements for the likes of Barclays, HSBC,Lloyds, and Royal Bank of Scotland, couldfurther choke off the supply of credit, hurting the economy.
"(Standardised risk weights) is a blunt tool but it givesyou consistency across the banks," a senior official at a topBritish bank said, adding the flip side was that the blunter itwas, the more banks with better risk management get punished.
Lenders are under huge pressure to have higher capitalratios as new global rules, known as Basel III, are phased inthis year to prevent a repeat of the 2007-09 financial crisis.
To meet the new rules, lenders are cutting theirrisk-weighted assets (RWAs) through disposals, by cutting riskybusinesses, and hedging. They are also tinkering with theirinternal models to make their holdings appear less risky,undermining the credibility of Basel III.
"The Basel rules stand or fall by the RWA calculations. Ifthere are questions on how banks calculate their RWAs, the rightamount of capital is almost a moot point if you cannot trust thedenominator," 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 banksare gaming the system. But there is an absence of proof thatthey are not."
Deutsche Bank said last month changes to itsmodel had helped cut RWAs by 55 billion euros in the fourthquarter, boosting its capital ratio. Finance chief Stefan Krausedefended the changes, saying the German lender's models wouldhold up amid moves to harmonize RWAs globally.
Both Basel regulators and the Bank of England say banks haveshown wide variance in assessing risk in a sample portfolio ofassets. The most prudent British banks estimated they neededmore than three times as much capital as the most aggressivebanks for the same assets, the BoE said.
The Bank of England has estimated the capital shortfall forBarclays, HSBC, Lloyds and RBS could be as much as 35 billionpounds ($53 billion) if weightings were standardised.
Barclays last week increased its RWAs by 20 billion poundsto reflect methodology changes, effectively meaning it needs tohold 2 billion pounds more capital. It was allowed to increaseits dividend, however, which analysts said showed the FSA wascomfortable with its capital strength.
State-backed lenders Lloyds and RBS could be most affectedby the stricter rules as they have thinner capital cushions thanrivals and the large size of their loan books means even smallchanges in risk weightings can have a significant impact,several bankers and analysts said.
RBS said last year stricter rules will add 50-65 billionpounds to its RWAs by the end of 2013. Banks were expected togive 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 possiblelosses on British, U.S. and other government bonds.
That bumped up risk weightings on sovereign debt by about athird, bankers said, at a time when banks were being told tohold 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, saidin November the way that banks calculated RWAs was too "complexand opaque" and needed fixing. The FSA was told to assess theproblem and report back for a March 19 FPC meeting.
The FSA had already forced banks to attach a higher risk tocorporate loans and government bonds, meaning they have to setaside more capital to cover potential losses. It is alsoassessing mortgages, mirroring a more conservative approachbeing taken in Sweden and Switzerland.
The FSA was not expected to go as far in standardisingresidential mortgages risk as it went with commercial loans, butone option is to set a minimum level, as Sweden has done.
The FSA, like other national regulators, has been approvinglarge banks' internal risk model for years, but only in the past18 months did it acquire specialist teams to better questionmodels, a senior industry source said.
The FSA's most significant change has been to standardisethe way commercial real estate loans are assessed.
Known as "slotting", loans are put in one of four categoriesand given the same risk weighting across all lenders. It meansbanks must hold billions more capital, which is being phased inand due to be fully in place by the end of this year.
It is unclear how far and fast the next phase of change willbe. Andrew Bailey, the regulator overseeing the assessment, saidlast week it was "a delicate issue".
A senior executive at a British bank said there wassignificant danger in imposing standardised weightings andignoring historical models and differences across banks in theirrisk management skills, how losses are defined and theirattitudes to collecting losses.
"Abandoning a risk sensitive approach to the capital heldagainst a given asset in favour of a more standardised approachwould actually introduce more risk into the financial system."
The discrepancy in banks' models and the lack oftransparency are deterring investors - more than 60 percent ofinvestors surveyed by Barclays analysts last year said they hadlost confidence in RWAs.
To help address those concerns, some of the biggest bankshave agreed to give more detail on how their RWAs arecalculated, under an initiative launched by the FinancialStability Board.
