Arbeitspapier

The limits of model-based regulation

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.

ISBN: 978-92-899-2176-3

Language: Englisch

Bibliographic citation: Series: ECB Working Paper ; No. 1928

Classification: Wirtschaft
Financial Crises
Banks; Depository Institutions; Micro Finance Institutions; Mortgages
Financial Institutions and Services: Government Policy and Regulation

Subject: Basel regulation
capital regulation
complexity of regulation
internal ratings

Event: Geistige Schöpfung

(who): Behn, Markus
Haselmann, Rainer
Vig, Vikrant

Event: Veröffentlichung

(who): European Central Bank (ECB)

(where): Frankfurt a. M.

(when): 2016

DOI: doi:10.2866/906624

Handle: http://hdl.handle.net/10419/154361

Last update: 10.03.2025, 11:43 AM CET

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Object type

Arbeitspapier

Associated

Behn, Markus
Haselmann, Rainer
Vig, Vikrant
European Central Bank (ECB)

Time of origin

2016

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