The limits of model-based regulation

Markus Behn, Rainer Haselmann () and Vikrant Vig

No 1928, Working Paper Series from European Central Bank

Abstract: In this paper, we investigate how the introduction of sophisticated, model-based capital regulation affected the measurement of credit risk by financial institutions. Model-based regulation was meant to enhance the stability of the financial sector by making capital charges more sensitive to risk. Exploiting the introduction of the model-based approach in Germany and the richness of our loan-level data set, we show that (1) internal risk estimates employed for regulatory purposes systematically underpredict actual default rates by 0.5 to 1 percentage points; (2) both default rates and loss rates are higher for loans that were originated under the model-based approach, while corresponding risk-weights are significantly lower; and (3) interest rates are higher for loans originated under the model-based approach, suggesting that banks were aware of the higher risk associated with these loans and priced them accordingly. Counter to the stated objective of the reform, financial institutions have lower capital charges and at the same time experience higher loan losses. Further, we document that large banks benefited from the reform as they experienced a reduction in capital charges and consequently expanded their lending at the expense of smaller banks that did not introduce the model-based approach. Overall, our results highlight that if the challenges that accompanies complex regulation are too high simpler rules may increase the efficacy of financial regulation. JEL Classification: G01, G21, G28

Keywords: Basel regulation; capital regulation; complexity of regulation; internal ratings (search for similar items in EconPapers)
Date: 2016-07
New Economics Papers: this item is included in nep-ban, nep-cba and nep-rmg
Note: 2203070
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (40)

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Related works:
Journal Article: The Limits of Model‐Based Regulation (2022)
Working Paper: The Limits of Model-Based Regulation (2021)
Working Paper: The limits of model-based regulation (2014)
Working Paper: The limits of model-based regulation (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:20161928

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