Strategic Selection of Risk Models and Bank Capital Regulation

55 Pages Posted: 3 Nov 2012 Last revised: 27 Aug 2014

Multiple version iconThere are 2 versions of this paper

Date Written: August 26, 2014

Abstract

Using banks' internal models for regulatory purposes, while aimed at making capital requirements more accurate, invites regulatory arbitrage. I show how the strategic use of risk models can be avoided by penalizing banks with low risk-weights when they suffer abnormal losses. As defaulting banks cannot be penalized, under tail risk uncertainty it is optimal to "reward" banks that truthfully reveal high risk measures by a commitment to bailing them out in case of default. Recent regulatory reforms that use floors on risk weights instead can be counter-productive when the issue is a "hidden model" problem and not model risk.

Keywords: Basel risk-weights, internal risk models, leverage ratio, tail risk

JEL Classification: D82, D84, G21, G32, G38

Suggested Citation

Colliard, Jean-Edouard, Strategic Selection of Risk Models and Bank Capital Regulation (August 26, 2014). Available at SSRN: https://ssrn.com/abstract=2170459 or http://dx.doi.org/10.2139/ssrn.2170459

Jean-Edouard Colliard (Contact Author)

HEC Paris - Finance Department ( email )

France