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Design of Risk Weights

32 Pages Posted: 25 May 2013  

Paul Glasserman

Columbia Business School

Wanmo Kang

Korea Advanced Institute of Science and Technology (KAIST) - Department of Mathematical Science

Date Written: May 23, 2013

Abstract

Banking regulations set minimum levels of capital for banks. These requirements are generally formulated through a ratio of capital to risk-weighted assets. A risk-weighting scheme assigns a weight to each asset or category of assets and effectively functions as a linear constraint on a bank’s portfolio choice; it also changes the incentives for banks to hold various kinds of assets. In this paper, we investigate the design of risk weights to align regulatory and private objectives in a simple mean-variance framework for portfolio selection. By setting risk weights proportional to profitability rather than risk, the regulator can induce a bank to reduce its overall level of risk without distorting its asset mix. Because the regulator is unlikely to know the true profitability of assets, we introduce an adaptive formulation in which the regulator sets weights by observing a bank’s portfolio. The adaptive scheme converges to the same combination of weights and portfolio choice that would hold if the regulator knew the asset profitability. We also investigate other objectives, including steering banks to a target mix of assets, adding robustness, mitigating procyclicality, and reducing system-wide risk in a setting with multiple heterogeneous banks.

Keywords: Capital requirements, risk-weighted assets

JEL Classification: G21, G11, G38

Suggested Citation

Glasserman, Paul and Kang, Wanmo, Design of Risk Weights (May 23, 2013). Columbia Business School Research Paper No. 13-39. Available at SSRN: https://ssrn.com/abstract=2269057 or http://dx.doi.org/10.2139/ssrn.2269057

Paul Glasserman (Contact Author)

Columbia Business School ( email )

3022 Broadway
403 Uris Hall
New York, NY 10027
United States
212-854-4102 (Phone)
212-316-9180 (Fax)

Wanmo Kang

Korea Advanced Institute of Science and Technology (KAIST) - Department of Mathematical Science ( email )

373-1 Kusong-dong
Yuson-gu
Taejon 305-701, 130-722
Korea

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