Why Do Banks Optimize Risk Weights? The Relevance of the Cost of Equity Capital

40 Pages Posted: 21 Apr 2013

See all articles by Andrea Beltratti

Andrea Beltratti

Bocconi University - Department of Finance

Giovanna Paladino

IntesaSanpaolo; LUISS Economics Department

Date Written: April 21, 2013

Abstract

Banks use internal models to optimize risk weights and better account for the specific risk of each asset class. As the choice of a set of risk weights directly amounts to affecting the regulatory capital ratio, economic theory suggests that banks should optimize their risk weights also with respect to the cost and benefit of holding equity capital. Banks with a higher cost of capital, and banks with better growth opportunities, should be more aggressive in reducing risk weights. We consider a large panel of international banks and find that, after controlling for a number of bank and country characteristics, banks do respond to the cost and benefit of holding capital when selecting their average risk weights. We also find that banks that are more aggressive in terms of such optimization have a subsequent lower return on equity and are more likely to have raised capital during the credit crisis.

Keywords: Basel Accord, risk-weighted assets, internal rating models, panel OLS, dynamic system GMM

JEL Classification: G18, G21, C23

Suggested Citation

Beltratti, Andrea and Paladino, Giovanna, Why Do Banks Optimize Risk Weights? The Relevance of the Cost of Equity Capital (April 21, 2013). Available at SSRN: https://ssrn.com/abstract=2254420 or http://dx.doi.org/10.2139/ssrn.2254420

Andrea Beltratti (Contact Author)

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

Giovanna Paladino

IntesaSanpaolo ( email )

Piazza San Carlo
Torino, 10121
Italy

LUISS Economics Department ( email )

Viale di Villa Massimo, 57
Rome, 00161
Italy

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