International banking regulation and Tier 1 capital ratios. On the robustness of the critical average risk weight framework

Under Basel III, the new international banking regulation, banks must maintain two Tier 1 capital ratios that treat risky assets dierently. The Basel Committee uses the critical average risk weight (CARW) framework, developed by the Bank of England to determine which ratio is the binding constraint. This methodology, which implicitly assumes that each asset is subject to a uniform shock, consists in comparing the implied average risk weight of a bank to a regulatory critical threshold. Using a stress test approach, we examine whether, and under which conditions, the CARW framework identies the correct binding capital ratio. We nd important errors, that are attributable to incorrect data but surprisingly not to the CARW framework. We nally generalize the methodology used by the Basel Committee and show how our stress-test approach can be used to determine which ratio is binding when only a (single class of) asset(s) is shocked.