Back to the Roots of Internal Credit Risk Models: Does Risk Explain Why Banks’ Risk-Weighted Asset Levels Converge over Time?

Abstract

The internal ratings-based (IRB) approach maps banks’ risk profiles more adequately than the standardized approach. After switching to IRB, banks’ risk-weighted asset (RWA) densities are thus expected to diverge, especially across countries with different supervisory strictness and risk levels. However, when examining 52 listed banks headquartered in 14 European countries that adopted the IRB approach, we observe a convergence of their RWA densities over time. We test if this convergence can be entirely explained by differences in the size of the banks, loss levels, country risk, and/or time of IRB implementation, yet this is not the case. Whereas banks in high-risk countries, with lax regulation, reduce their RWA densities, banks elsewhere increase theirs. Especially for banks in high-risk countries, RWA densities underestimate banks’ actual economic risk. Hence, the IRB approach allows for regulatory arbitrage, whereby authorities only enforce strict supervision on capital requirements if they do not jeopardize bank resilience.

Keywords: Capital regulation, credit risk, internal ratings-based approach, regulatory arbitrage, risk-weighted assets

JEL Classification: G21, G28