Do Banks’ Internal Basel Risk Estimates Reflect Risk?

36 Pages Posted: 19 Jan 2013 Last revised: 22 May 2014

See all articles by Irina Barakova

Irina Barakova

Government of the United States of America - Office of the Comptroller of the Currency (OCC)

Ajay A. Palvia

Government of the United States of America - Office of the Comptroller of the Currency (OCC)

Date Written: February 1, 2014

Abstract

Using supervisory data for US banks, we evaluate the alignment of Basel II/III AIRB (Advanced Internal Ratings Based) risk estimates with portfolio risk. We use loan performance as a direct measure of portfolio risk as well as less direct market-based measures. Our results document that loan performance is highly correlated with AIRB risk weights and that, in contrast, Basel I risk weights are not reflective of loan performance. We find that capital requirements under the AIRB approach are higher than those under Basel I especially for portfolios recently under stress such as mortgages and some sovereign exposures. The alignment of Basel risk estimates with market-based risk indicators is less robust although, the association is nevertheless stronger for AIRB risk weights relative to Basel I. Our results support the view that internally generated risk weights are determined mostly by portfolio risk and are, as a result, substantially more risk sensitive then the fixed asset type based risk weights of Basel I.

Keywords: Basel II, Risk Weights, Capital

JEL Classification: G20, G21, G28

Suggested Citation

Barakova, Irina and Palvia, Ajay A., Do Banks’ Internal Basel Risk Estimates Reflect Risk? (February 1, 2014). Journal of Financial Stability, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2203104 or http://dx.doi.org/10.2139/ssrn.2203104

Irina Barakova

Government of the United States of America - Office of the Comptroller of the Currency (OCC) ( email )

400 7th Street SW
Washington, DC 20219
United States

Ajay A. Palvia (Contact Author)

Government of the United States of America - Office of the Comptroller of the Currency (OCC) ( email )

400 7th Street SW
Washington, DC 20219
United States

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