The Limits of Model-based Regulation

59 Pages Posted: 5 Jul 2016

See all articles by Markus Behn

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: July 4, 2016

Abstract

In this paper, we investigate how the introduction of sophisticated, model-based capital regulation affected the measurement of credit risk by 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 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. Counter to the stated objective of the reform, financial institutions have lower capital charges and at the same time experience higher loan losses.

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. Overall, our results highlight that if the challenges that accompanies complex regulation are too high simpler rules may increase the efficacy of financial regulation.

Keywords: capital regulation, internal ratings, complexity of regulation, 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 (July 4, 2016). ECB Working Paper No. 1928. Available at SSRN: https://ssrn.com/abstract=2804598

Markus Behn (Contact Author)

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

London Business School ( email )

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

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