The Manipulation of Basel Risk-Weights Mike Mariathasan University of Oxford Ouarda Merrouche Graduate Institute, Geneva CONSOB-BOCCONI Conference on Banks, Markets and Financial Innovation; presented by: Charlotte Werger, EUI May 22, 2013
Introduction Bank capital regulation core of (microprudential) bank regulation global standards continuously revised: Basel I, Basel II, Basel III,... dual objective: enhances shareholder monitoring ex ante protects depositors (tax payer) ex post trade-off: stability inefficient funding structure central element: minimum capital requirement x, risk-weighted assets (RWA) = i A i ω i E RWA x
Introduction Basel risk-weights idea: more risky assets require more monitoring/ larger buffer Basel I: regulator decides riskiness of the asset & assigns risk-weight few & simple risk categories (simpler than banks risk models) Basel II: more complex risk categories external credit ratings (Standard Approach, SA) internal models (Internal Ratings-Based Approach, IRB) F-IRB: banks calculate PD, (M) A-IRB: banks calculate PD, LGD, EAD, M Basel III: more of the same, but better (Haldane, 2011) internal models still used literature: limited risk-sensitivity of risk-weights under IRB
Introduction Basel risk-weights idea: more risky assets require more monitoring/ larger buffer Basel I: regulator decides riskiness of the asset & assigns risk-weight few & simple risk categories (simpler than banks risk models) Basel II: more complex risk categories external credit ratings (Standard Approach, SA) internal models (Internal Ratings-Based Approach, IRB) F-IRB: banks calculate PD, (M) A-IRB: banks calculate PD, LGD, EAD, M Basel III: more of the same, but better (Haldane, 2011) internal models still used literature: on-going search for determinants
Introduction Basel risk-weights idea: more risky assets require more monitoring/ larger buffer Basel I: regulator decides riskiness of the asset & assigns risk-weight few & simple risk categories (simpler than banks risk models) Basel II: more complex risk categories external credit ratings (Standard Approach, SA) internal models (Internal Ratings-Based Approach, IRB) F-IRB: banks calculate PD, (M) A-IRB: banks calculate PD, LGD, EAD, M Basel III: more of the same, but better (Haldane, 2011) internal models still used literature: incentives for banks to misreport risk (Blum, 2008)
Contribution This paper does the data support Blum (2008) s hypotheses?
Contribution This paper does the data support Blum (2008) s hypotheses? average reported riskiness ( RWA ) declined upon IRB adoption TA specifically for weakly capitalised banks
Contribution This paper does the data support Blum (2008) s hypotheses? average reported riskiness ( RWA ) declined upon IRB adoption TA specifically for weakly capitalised banks competing explanations IRB induced re-allocation of resources towards safer assets Risk-weights implied by Basel I were fundamentally too high IRB weights are too low (by accident) IRB weights are too low (intentionally)
Contribution This paper does the data support Blum (2008) s hypotheses? average reported riskiness ( RWA ) declined upon IRB adoption TA specifically for weakly capitalised banks competing explanations IRB induced re-allocation of resources towards safer assets Risk-weights implied by Basel I were fundamentally too high IRB weights are too low (by accident) IRB weights are too low (intentionally) corresponding empirical predictions
Contribution This paper does the data support Blum (2008) s hypotheses? average reported riskiness ( RWA ) declined upon IRB adoption TA specifically for weakly capitalised banks competing explanations IRB induced re-allocation of resources towards safer assets Risk-weights implied by Basel I were fundamentally too high IRB weights are too low (by accident) IRB weights are too low (intentionally) corresponding empirical predictions no effect when controlling for loan categories
Contribution This paper does the data support Blum (2008) s hypotheses? average reported riskiness ( RWA ) declined upon IRB adoption TA specifically for weakly capitalised banks competing explanations IRB induced re-allocation of resources towards safer assets Risk-weights implied by Basel I were fundamentally too high IRB weights are too low (by accident) IRB weights are too low (intentionally) corresponding empirical predictions effect should disappear when controlling for loan categories banks should be able to reduce capital and remain stable
Contribution This paper does the data support Blum (2008) s hypotheses? average reported riskiness ( RWA ) declined upon IRB adoption TA specifically for weakly capitalised banks competing explanations IRB induced re-allocation of resources towards safer assets Risk-weights implied by Basel I were fundamentally too high IRB weights are too low (by accident) IRB weights are too low (intentionally) corresponding empirical predictions effect should disappear when controlling for loan categories banks should be able to reduce capital and remain stable very hard to distinguish
Contribution This paper does the data support Blum (2008) s hypotheses? average reported riskiness ( RWA ) declined upon IRB adoption TA specifically for weakly capitalised banks competing explanations IRB induced re-allocation of resources towards safer assets Risk-weights implied by Basel I were fundamentally too high IRB weights are too low (by accident) IRB weights are too low (intentionally) corresponding empirical predictions effect should disappear when controlling for loan categories banks should be able to reduce capital and remain stable supervisory scrutiny should matter more in case of intention
Contribution This paper does the data support Blum (2008) s hypotheses? average reported riskiness ( RWA ) declined upon IRB adoption TA specifically for weakly capitalised banks competing explanations IRB induced re-allocation of resources towards safer assets Risk-weights implied by Basel I were fundamentally too high IRB weights are too low (by accident) IRB weights are too low (intentionally) corresponding empirical predictions effect should disappear when controlling for loan categories banks should be able to reduce capital and remain stable supervisory scrutiny should matter more in case of intention would expect faulty models to imply more impaired loans
Motivation RWA TA (%) before & after IRB adoption 50 55 60 65 70 75 Resolved Not resolved Full implementation of the advanced approach -10-5 0 5 10 Quarters before and after implementation strong decline and leveling with non-resolved banks afterwards harder to disentangle stable from fragile banks
Setup Sample 115 banks that have been approved for IRB adoption A-IRB & F-IRB mostly for corporate & retail loans 77% of assets covered on average annual balance sheet data, 2004-10 (Bankscope) 21 OECD countries
Setup Model RWA = α 0 + α 1 1 IRB i,t + β X i,t + u i,t TA i,t 1 IRB i,t : IRB adoption dummy (= 1, for t implementation date) X i,t : control variables Ln(TA), GDP growth, year dummies, bank FE Bank level: gross loans, corporate loans, residential loans, liquid assets Country level: short-term rate, public debt/ GDP interaction effects variations of the LHS variable cross-sectional panel regressions (fixed effects) clustered standard errors (country level)
Results IRB adoption associated with lower reported riskiness magnitude: 0.0293 0.64 bp change in the CAR A-IRB vs. F-IRB does not seem to matter (low coverage for A-IRB?) degree of coverage appears to be secondary (little variation?)
Results Explanation 1: IRB induced re-allocation of resources towards safer assets
Results consistent with re-allocation of resources (column 1) weakly capitalised banks report (relatively) lower riskiness (Blum, 2008)
Results Explanation 2: Risk-weights implied by Basel I were fundamentally too high
Results well capitalised banks increase capital after IRB adoption not weakly capitalised banks consistent with justified adjustment, but...
Results ex post capital was fundamentally too low
Results Explanations 3 & 4: Models implied too little capital. By accident, or intentionally?
Results more supervisory scrutiny associated with higher reported riskiness
Results more supervisory scrutiny associated with higher reported riskiness
Results results robust at the country level
Results consistent with misconduct
Results consistent with misconduct but:
Results consistent with misconduct but: closer supervision could also enhance model quality
Results consistent with misconduct but: closer supervision could also enhance model quality additional evidence: prudence more generally & loan quality
Results credit risk not systematically underestimated by weakly capitalised banks weakly capitalised banks behave less prudently
Results credit risk not systematically underestimated by weakly capitalised banks weakly capitalised banks behave less prudently
Results credit risk not systematically underestimated by weakly capitalised banks weakly capitalised banks behave less prudently
Results credit risk not systematically underestimated by weakly capitalised banks weakly capitalised banks behave less prudently
Conclusions Internal risk-models under Basel II have lead to a reduction in reported riskiness less if banks are better capitalised & more if supervision is weak Consistent with Blum (2008) s model DIY capital hypothesis Lessons for regulation value of simple & transparent rules tight auditing rules could complement regulation leverage-dependent scaling factor? Basel III goes in the right direction (leverage ratio constraint)