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
Date Written: December 12, 2019
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: Suggested Citation