Credit Risk in European Banks: The Bright Side of the Internal Ratings Based Approach

Abstract

This paper investigates the accuracy of internal rating based (IRB) models in measuring credit risk. We contribute to the growing debate on the current prudential regulatory framework by investigating the use of validated IRB models in promoting efficient risk management practises. Our empirical analysis is based on a novel panel data set of 177 Western European banks observed from 2008 to 2015, in the aftermath of the financial and economic crisis. We find that IRB banks were able to curb the increase in credit risk driven by the macroeconomic slowdown better than banks under the standardized approach. This suggests that the introduction of the internal ratings based approach by Basel II has promoted the adoption of stronger risk management practices among banks, as meant by the regulators.

Keywords: Internal Ratings Based approach; credit risk; prudential regulation; dynamic panels; state dependent endogenous dummy; System GMM

JEL Classification: G21; C23