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Strategic Selection of Risk Models and Bank Capital Regulation

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  • Jean-Edouard Colliard

    (Finance Department, HEC Paris, 78351 Jouy-en-Josas, France)

Abstract

The regulatory use of banks’ internal models makes capital requirements more risk sensitive but invites regulatory arbitrage. I develop a framework to study bank regulation with strategic selection of risk models. A bank supervisor can discourage arbitrage by auditing risk models and implements capital ratios less risk sensitive than in the first-best to reduce auditing costs. The optimal capital ratios of a national supervisor can be different from those set by supranational authorities, in which case the supervisor optimally tolerates biased models. I discuss the empirical implications of this “hidden model” problem, and policy answers such as leverage ratios and more reliance on backtesting mechanisms. The online appendix is available at https://doi.org/10.1287/mnsc.2017.2898 . This paper was accepted by Amit Seru, finance.

Suggested Citation

  • Jean-Edouard Colliard, 2019. "Strategic Selection of Risk Models and Bank Capital Regulation," Management Science, INFORMS, vol. 67(6), pages 2591-2606, June.
  • Handle: RePEc:inm:ormnsc:v:65:y:2019:i:6:p:2591-2606
    DOI: 10.1287/mnsc.2017.2898
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    Cited by:

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    2. Ding, Haina & Guembel, Alexander, 2020. "Market Information in Banking Supervision: The Role of Stress Test Design," TSE Working Papers 20-1144, Toulouse School of Economics (TSE).
    3. Ahnert, Toni & Chapman, James & Wilkins, Carolyn, 2021. "Should bank capital regulation be risk sensitive?," Journal of Financial Intermediation, Elsevier, vol. 46(C).
    4. Evren Ors, 2020. "Discussion of Becker, Bos, and Roszbach," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 52(S1), pages 143-147, October.

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    More about this item

    Keywords

    Basel risk weights; internal risk models; leverage ratio; supervisory audits;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation

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