The Limits of Model-Based Regulation

68 Pages Posted: 10 Aug 2021

See all articles by Markus Behn

Markus Behn

European Central Bank (ECB)

Rainer F. H. Haselmann

Goethe University Frankfurt - Faculty of Economics and Business Administration; Leibniz Institute for Financial Research SAFE

Vikrant Vig

London Business School

Multiple version iconThere are 3 versions of this paper

Date Written: August 10, 2021

Abstract

Using loan-level data from Germany, we investigate how the introduction of model-based capital regulation affected banks’ ability to absorb shocks. The objective of this regulation was to enhance financial stability by making capital requirements responsive to asset risk. Our evidence suggests that banks ‘optimized’ model-based regulation to lower their capital requirements. Banks systematically underreported risk, with under reporting being more pronounced for banks with higher gains from it. Moreover, large banks benefitted from the regulation at the expense of smaller banks. Overall, our results suggest that sophisticated rules may have undesired effects if strategic misbehavior is difficult to detect.

Suggested Citation

Behn, Markus and Haselmann, Rainer F. H. and Vig, Vikrant, The Limits of Model-Based Regulation (August 10, 2021). Journal of Finance, Forthcoming, LawFin Working Paper No. 20, Available at SSRN: https://ssrn.com/abstract=3902462

Markus Behn

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Rainer F. H. Haselmann (Contact Author)

Goethe University Frankfurt - Faculty of Economics and Business Administration ( email )

Mertonstrasse 17-25
Frankfurt am Main, D-60325
Germany

Leibniz Institute for Financial Research SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

Vikrant Vig

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

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