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The manipulation of basel risk-weights

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  • Mariathasan, Mike
  • Merrouche, Ouarda

Abstract

In this paper, we examine the relationship between banks’ approval for the internal ratings-based (IRB) approaches of Basel II and the ratio of risk-weighted assets to total assets. Analysing a panel of 115 banks from 21 OECD countries that were eventually approved for applying the IRB to their credit portfolio, we find that risk-weight density becomes lower once regulatory approval is granted. The effect persists when we control for asset structure, and we provide evidence showing that this phenomenon cannot be explained by modelling choices, or improved risk-measurement alone. Consistent with theories of risk-weight manipulation, we find the decline in risk-weights to be particularly pronounced among weakly capitalised banks, where the legal framework for supervision is weak, and in countries where supervisors are overseeing many IRB banks. We conclude that part of the decline in reported riskiness under the IRB results from banks’ strategic risk-modelling.

Suggested Citation

  • Mariathasan, Mike & Merrouche, Ouarda, 2014. "The manipulation of basel risk-weights," Journal of Financial Intermediation, Elsevier, vol. 23(3), pages 300-321.
  • Handle: RePEc:eee:jfinin:v:23:y:2014:i:3:p:300-321
    DOI: 10.1016/j.jfi.2014.04.004
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    Keywords

    Basel II; Internal ratings-based approach; Capital regulation;

    JEL classification:

    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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