The Limits of Model-Based Regulation

Abstract

In this paper, we investigate how the introduction of complex, model-based capital regulation affected credit risk of financial institutions. Model-based regulation was meant to enhance the stability of the financial sector by making capital charges more sensitive to risk. Exploiting the staggered introduction of the model-based approach in Germany and the richness of our loan-level data set, we show that (1) internal risk estimates employed for regulatory purposes systematically underpredict actual default rates by 0.5 to 1 percentage points; (2) both default rates and loss rates are higher for loans that were originated under the model-based approach, while corresponding risk-weights are significantly lower; and (3) interest rates are higher for loans originated under the model-based approach, suggesting that banks were aware of the higher risk associated with these loans and priced them accordingly. Further, we document that large banks benefited from the reform as they experienced a reduction in capital charges and consequently expanded their lending at the expense of smaller banks that did not introduce the model-based approach. Counter to the stated objectives, the introduction of complex regulation adversely affected the credit risk of financial institutions. Overall, our results highlight the pitfalls of complex regulation and suggest that simpler rules may increase the efficacy of financial regulation.

Did the Basel Process of Capital Regulation Enhance the Resiliency of European Banks?

“…While providing increasing incentives for prudent in-house risk management over time, regulators effectively also tolerated carve-outs of bank equity, and thus a serious decline in resiliency, particularly for the large and systemically most important banks after 2005. This is consistent with the view that risk models were chosen strategically (see Behn, Haselmann and Vig (2014) and Colliard (2015), but also Admati and Hellwig (2013).) Ironically, these carve-outs were one way of increasing return on equity through extensive stock repurchases at a time, when the cost of bank equity was actually low, and strengthening capitalization and resiliency was relatively cheap (in historical context).…”

Did the Basel Process of Capital Regulation Enhance the Resiliency of European Banks

“…Finally, concerning internal credit risk models we confirm and extend the re-sults of Behn, Haselmann and Vig (2014) about the limitations of model-based regulation. Also they find negative effects of internal models for credit risk on the resiliency of German banks.…”

Incentive-Based Capital Requirements

“…To quantify these parameters, the regulator must be able to evaluate the risks of the bank's investments. However, the 2008-2009 financial crisis revealed that risk modeling in the financial sector has strong limits (e.g., Danielsson (2002), Danielsson (2008), Hellwig (2010), Behn, Haselmann, and Vig (2014), and Rajan, Seru, and Vig (2015)). …”

“…However, the 2008-2009 financial crisis revealed that measuring bank asset risk is a difficult task because risk modeling per se has strong limitations (Danielsson, 2002(Danielsson, , 2008Hellwig, 2010;Rajan, Seru, and Vig, 2015). In addition, with risk-weighted capital requirements, banks have an incentive to understate their asset risk (Behn, Haselmann, and Vig, 2014) and to engage in regulatory capital arbitrage (e.g., Cochrane, 2014).…”