Do Banks’ Internal Basel Risk Estimates Reflect Risk?
36 Pages Posted: 19 Jan 2013 Last revised: 22 May 2014
Date Written: February 1, 2014
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: Suggested Citation