Revisiting Basel Risk Weights – Cross-Sectional Risk Sensitivity and Cyclicality

Journal of Business Economics 86 (8/2016), 905–931

44 Pages Posted: 30 Oct 2015 Last revised: 24 Feb 2017

See all articles by Rainer Baule

Rainer Baule

University of Hagen

Christian Tallau

Münster University of Applied Sciences

Date Written: March 4, 2016

Abstract

We empirically assess the sensitivity of Basel risk weights to bank portfolio risk and the business cycle. With our econometric model, we distinguish between cross-sectional risk sensitivity and longitudinal risk sensitivity (cyclicality) of the regulatory standard. Employing a comprehensive data set covering 200 large banks from 28 countries, we find that actual risk weights are fairly insensitive to the business cycle. There is no evidence that Basel II has significantly increased cyclicality. Furthermore, cross-sectional risk sensitivity of regulatory risk weights to a market measure of bank portfolio risk is low. We further assess the adequacy of the capital standard's risk sensitivity based on a Merton-style model of bank risk and bank default. Judged upon the Basel Committee's self-established goal of maintaining bank default rates below 0.1%, our results suggest that risk weights and minimum capital requirements are ill-calibrated, even under the stricter Basel III rules.

Keywords: Basel II, Risk weights, Banking regulation, Capital requirements, Pro-cyclicality

JEL Classification: G21, G28

Suggested Citation

Baule, Rainer and Tallau, Christian, Revisiting Basel Risk Weights – Cross-Sectional Risk Sensitivity and Cyclicality (March 4, 2016). Journal of Business Economics 86 (8/2016), 905–931. Available at SSRN: https://ssrn.com/abstract=2683993 or http://dx.doi.org/10.2139/ssrn.2683993

Rainer Baule

University of Hagen ( email )

Universitaetsstrasse 41
Hagen, 58097
Germany

Christian Tallau (Contact Author)

Münster University of Applied Sciences ( email )

Corrensstrasse 25
Muenster, 48149
Germany

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