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Why do banks optimize risk weights? The relevance of the cost of equity capital

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  • Beltratti, Andrea
  • Paladino, Giovanna
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    Abstract

    Banks use internal models to optimize risk weights and better account for the specific risk of each asset class. As the choice of a set of risk weights directly amounts to affecting the regulatory capital ratio, economic theory suggests that banks should optimize their risk weights also with respect to the cost and benefit of holding equity capital. Banks with a higher cost of capital, and banks with better growth opportunities, should be more aggressive in reducing risk weights. We consider a large panel of international banks and find that, after controlling for a number of bank and country characteristics, banks do respond to the cost and benefit of holding capital when selecting their average risk weights. We also find that banks that are more aggressive in terms of such optimization have a subsequent lower return on equity and are more likely to have raised capital during the credit crisis.

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    Bibliographic Info

    Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 46410.

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    Date of creation: 21 Apr 2013
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    Handle: RePEc:pra:mprapa:46410

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    Keywords: Basel Accord; risk-weighted assets; internal rating models; panel OLS; dynamic system GMM.;

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