Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/154361
Authors: 
Behn, Markus
Haselmann, Rainer
Vig, Vikrant
Year of Publication: 
2016
Series/Report no.: 
ECB Working Paper 1928
Abstract: 
In this paper, we investigate how the introduction of sophisticated, model-based capital regulation affected the measurement of credit risk by 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 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. Counter to the stated objective of the reform, financial institutions have lower capital charges and at the same time experience higher loan losses. 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. Overall, our results highlight that if the challenges that accompanies complex regulation are too high simpler rules may increase the efficacy of financial regulation.
Subjects: 
Basel regulation
capital regulation
complexity of regulation
internal ratings
JEL: 
G01
G21
G28
Persistent Identifier of the first edition: 
ISBN: 
978-92-899-2176-3
Document Type: 
Working Paper

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