Strategic Selection of Risk Models and Bank Capital Regulation

Forthcoming, Management Science

HEC Paris Research Paper No. 1229

55 Pages Posted: 18 Sep 2017 Last revised: 29 Nov 2017

Multiple version iconThere are 2 versions of this paper

Date Written: September 7, 2017

Abstract

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

Colliard, Jean-Edouard, Strategic Selection of Risk Models and Bank Capital Regulation (September 7, 2017). Forthcoming, Management Science; HEC Paris Research Paper No. 1229. Available at SSRN: https://ssrn.com/abstract=3037402 or http://dx.doi.org/10.2139/ssrn.3037402

Jean-Edouard Colliard (Contact Author)

HEC Paris - Finance Department ( email )

France

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