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Banks, Internal Models and the Problem of Adverse Selection

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  • Ewerhart II, Christian

    (Sonderforschungsbereich 504)

Abstract

Recent empirical studies indicate that financial institutions tend to overestimate their market risks in disclosures to supervisory authorities. The evidence is surprising because overstated risk figures imply a costly restriction to the bank's trading activity. This paper offers a stylized model of the regulatory process, in which conservative risk reporting is the consequence of an adverse selection problem between bank and regulator. The analysis suggests that efficiency gains may be feasible when regulators disencourage conservative reporting especially for banks with a history of low capital ratios. The basic argument applies also to the internal ratings-based approach to credit risk supervision. The results have an immediate bearing on the recently proposed Basle II framework.

Suggested Citation

  • Ewerhart II, Christian, 2002. "Banks, Internal Models and the Problem of Adverse Selection," Sonderforschungsbereich 504 Publications 02-14, Sonderforschungsbereich 504, Universität Mannheim;Sonderforschungsbereich 504, University of Mannheim.
    • Handle: RePEc:xrs:sfbmaa:02-14
    Note: Financial support from the Deutsche Forschungsgemeinschaft, SFB 504, at the University of Mannheim, is gratefully acknowledged.
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    Cited by:

    1. Philippe Jorion, 2007. "Bank Trading Risk and Systemic Risk," NBER Chapters, in: The Risks of Financial Institutions, pages 29-57, National Bureau of Economic Research, Inc.
    2. Chen, Qian & Gerlach, Richard H., 2013. "The two-sided Weibull distribution and forecasting financial tail risk," International Journal of Forecasting, Elsevier, vol. 29(4), pages 527-540.

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