Regulatory Capital and Incentives for Risk Model Choice under Basel 3
55 Pages Posted: 12 Aug 2020
Date Written: July 14, 2020
In response to the Subprime Mortgage crisis, the Basel Committee on Banking Supervision (BCBS) has spent the previous decade overhauling the regulatory framework that governs how banks calculate minimum capital requirements. In 2019, the BCBS finalized the Basel 3 regulatory regime, which changes the regulatory measure of market risk and adds new complex calculations based on liquidity and risk factors. This paper is motivated by these changes and seeks to answer the question of how regulation affects banks' choice of risk-management models, whether it incentivizes them to use correctly specified models, and if it results in more stable capital requirements. Our results show that, although the models that minimize regulatory capital for a representative bank portfolio also result in the most stable requirements, these models are generally rejected as being correctly specified and tend to produce inferior forecasts of the regulatory risk measures.
Keywords: Basel 3, Expected Shortfall Backtesting, Regulatory Capital Requirements
JEL Classification: C14, C22, C53, G32
Suggested Citation: Suggested Citation