Banks' Next Top Model

Abstract

The global financial crisis has led to the increasing importance of regulation that relies on banks’ internal risk models. Model-based regulation aims at incentivizing banks to accurately measure risk via constantly evolving models. This paper offers a theoretical model that explores how banks’ risk tolerance affects the optimal trade-offs between capital requirements and penalties for underreporting risk. The model suggests that an increase in banks’ risk tolerance leads to higher penalties for underreporting risk. I then use hand-collected data on banks’ model revisions and outcomes. I document that banks systematically underreport risk and despite the pressure from regulators do not improve the internal models. The paper suggests that model-based regulation is flawed and calls for more supervisory training to alleviate the inefficiencies.

Keywords: Basel Regulation, Internal Models, Capital Requirements, Market Risk

JEL Classification: D82, D86, G01, G21, G28