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

Author

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  • Beltratti, Andrea
  • Paladino, Giovanna

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.

Suggested Citation

  • Beltratti, Andrea & Paladino, Giovanna, 2013. "Why do banks optimize risk weights? The relevance of the cost of equity capital," MPRA Paper 46410, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:46410
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    File URL: https://mpra.ub.uni-muenchen.de/46410/1/MPRA_paper_46410.pdf
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    References listed on IDEAS

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    Cited by:

    1. Waeibrorheem Waemustafa & Suriani Sukri, 2015. "Bank Specific and Macroeconomics Dynamic Determinants of Credit Risk in Islamic Banks and Conventional Banks," International Journal of Economics and Financial Issues, Econjournals, vol. 5(2), pages 476-481.
    2. Brunella Bruno & Giacomo Nocera & Andrea Resti, 2015. "The credibility of European banks’ risk-weighted capital: structural differences or national segmentations?," BAFFI CAREFIN Working Papers 1509, BAFFI CAREFIN, Centre for Applied Research on International Markets Banking Finance and Regulation, Universita' Bocconi, Milano, Italy.
    3. Marco Pagano, 2014. "Lessons from the European Financial Crisis," CSEF Working Papers 370, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.

    More about this item

    Keywords

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

    JEL classification:

    • C23 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Models with Panel Data; Spatio-temporal Models
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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