The Risk Sensitivity of Basel Risk Weights and Loan Loss Provisions: Evidence from European Banks

48 Pages Posted: 8 Apr 2017 Last revised: 12 Dec 2019

See all articles by Rainer Baule

Rainer Baule

University of Hagen

Christian Tallau

Münster University of Applied Sciences

Date Written: December 12, 2019

Abstract

Recent literature suggests that regulatory risk measures do not adequately capture the actual economic risk of bank portfolios. We shed new light on this issue by analyzing both unexpected and expected losses and their assessment according to regulatory and accounting standards. Examining a sample of large European banks for the years 2002-2015, we show that regulatory risk sensitivity, i.e., the response of Basel risk weights to asset volatility as our measure of a bank's asset portfolio risk, is substantially higher than what has been shown so far in the literature. Despite the occasionally bad reputation that risk weights have, we provide new evidence that they are adequately calibrated for banks with low or medium levels of risk. For crisis periods and for high-risk banks, however, risk weights still do not adequately reflect the actual portfolio risk. This results in insufficient capital, even with the stricter Basel III minimum capital requirements. Regarding expected losses, as reflected in loan loss allowances, we establish a theoretical link to asset volatility. We document a strong empirical association, that fits well to the theoretical model. Overall, we find no indication that the risk sensitivity regarding loan loss allowances has been insufficient, at least since the financial crisis.

Keywords: risk weights, expected losses, loan loss provisioning, banking regulation, capital requirements, Basel II

JEL Classification: G21, G28

Suggested Citation

Baule, Rainer and Tallau, Christian, The Risk Sensitivity of Basel Risk Weights and Loan Loss Provisions: Evidence from European Banks (December 12, 2019). Available at SSRN: https://ssrn.com/abstract=2948314 or http://dx.doi.org/10.2139/ssrn.2948314

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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