The risk sensitivity of Basel risk weights and loan loss provisions: evidence from European banks

Rainer Baule and Christian Tallau

The European Journal of Finance, 2021, vol. 27, issue 18, 1855-1886

Abstract: Recent literature suggests that regulatory risk measures do not adequately capture the actual economic risk of bank portfolios. We shed new light on this issue by analyzing both regulatory and accounting standards, i.e. capital requirements and loan loss provisions. Examining a sample of large European banks for the years 2002–2015, we show that regulatory risk sensitivity, i.e. the response of Basel risk weights to asset volatility as our measure of a bank's asset portfolio risk, is substantially higher than what has been shown so far in the literature. Despite the occasionally bad reputation that risk weights have, we provide new evidence that they are adequately calibrated for banks with low or medium levels of risk. For crisis periods and for high-risk banks, however, risk weights still do not adequately reflect the actual portfolio risk. This results in insufficient capital, even with the stricter Basel III minimum capital requirements. Regarding loan loss provisions, we establish a theoretical link between expected losses and asset volatility. We document a strong empirical association, which fits well to the theoretical model. Overall, we find no indication that the risk sensitivity of loan loss provisions has been insufficient, at least since the financial crisis.

Date: 2021
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DOI: 10.1080/1351847X.2021.1918207

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