The limits of model-based regulation

Markus Behn, Rainer Haselmann () and Vikrant Vig

No 75, SAFE Working Paper Series from Leibniz Institute for Financial Research SAFE

Abstract: In this paper, we investigate how the introduction of complex, model-based capital regulation affected credit risk of 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 staggered 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. 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. Counter to the stated objectives, the introduction of complex regulation adversely affected the credit risk of financial institutions. Overall, our results highlight the pitfalls of complex regulation and suggest that simpler rules may increase the efficacy of financial regulation.

Keywords: capital regulation; internal ratings; Basel regulation (search for similar items in EconPapers)
JEL-codes: G01 G21 G28 (search for similar items in EconPapers)
Date: 2014
New Economics Papers: this item is included in nep-ban, nep-cba and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (32)

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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 (2016)
Working Paper: The limits of model-based regulation (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:zbw:safewp:75

DOI: 10.2139/ssrn.2523383

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