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The Limits of Model-Based Regulation

SAFE Working Paper No. 75

52 Pages Posted: 13 Nov 2014 Last revised: 1 Dec 2014

Markus Behn

European Central Bank (ECB)

Rainer F. H. Haselmann

Goethe University Frankfurt - Research Center SAFE; Goethe University Frankfurt - Faculty of Economics and Business Administration

Vikrant Vig

London Business School

Multiple version iconThere are 2 versions of this paper

Date Written: November 30, 2014

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

JEL Classification: G01, G21, G28

Suggested Citation

Behn, Markus and Haselmann, Rainer F. H. and Vig, Vikrant, The Limits of Model-Based Regulation (November 30, 2014). SAFE Working Paper No. 75. Available at SSRN: https://ssrn.com/abstract=2523383 or http://dx.doi.org/10.2139/ssrn.2523383

Markus Behn

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Rainer F. H. Haselmann

Goethe University Frankfurt - Research Center SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

Goethe University Frankfurt - Faculty of Economics and Business Administration ( email )

Mertonstrasse 17-25
Frankfurt am Main, D-60325
Germany

Vikrant Vig (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

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