Strategic Selection of Risk Models and Bank Capital Regulation
Forthcoming, Management Science
55 Pages Posted: 18 Sep 2017 Last revised: 29 Nov 2017
Date Written: September 7, 2017
The regulatory use of banks' internal models makes capital requirements more risk-sensitive but invites regulatory arbitrage. I develop a framework to study bank regulation with strategic selection of risk models. A bank supervisor can discourage arbitrage by auditing risk models, and implements capital ratios less risk-sensitive than in the first-best to reduce auditing costs. The optimal capital ratios of a national supervisor can be different from those set by supranational authorities, in which case the supervisor optimally tolerates biased models. I discuss the empirical implications of this "hidden model" problem, and policy answers such as leverage ratios and more reliance on backtesting mechanisms.
Keywords: basel risk-weights, internal risk models, leverage ratio, supervisory audits
JEL Classification: D82, D84, G21, G32, G38
Suggested Citation: Suggested Citation