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Revisiting Basel risk weights: cross-sectional risk sensitivity and cyclicality

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Abstract

We empirically assess the sensitivity of Basel risk weights to bank portfolio risk and the business cycle. With our econometric model, we distinguish between cross-sectional risk sensitivity and longitudinal risk sensitivity (cyclicality) of the regulatory standard. Employing a comprehensive data set covering 200 large banks from 28 countries, we find that actual risk weights are fairly insensitive to the business cycle. There is no evidence that Basel II has significantly increased cyclicality. Furthermore, cross-sectional risk sensitivity of regulatory risk weights to a market measure of bank portfolio risk is low. We further assess the adequacy of the capital standard’s risk sensitivity based on a Merton-style model of bank risk and bank default. Judged upon the Basel Committee’s self-established goal of maintaining bank default rates below 0.1 %, our results suggest that risk weights and minimum capital requirements are ill-calibrated, even under the stricter Basel III rules.

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Notes

  1. While “cyclicality” of the capital regulation refers to adjustments of RWA and hence capital requirements to the business cycle, “pro-cyclicality” is usually used in reference to the amplification of the economic cycle by the dynamic interactions between the financial and the real sectors of the economy (Financial Stability Board 2009).

  2. In order to account for the perceived pro-cyclicality of the capital requirements, Basel III has introduced a counter-cyclical capital buffer above the regulatory minimum requirement. The buffer size is governed in a counter-cyclical manner according to variations in systemic risk to dampen the pro-cyclicality of bank lending.

  3. Following Ronn and Verma (1986), we assume that the face value of the debt, \(D_{i,t}\), is the present value of the default point (discounted by the risk-free rate).

  4. Note that this approach implicitly assumes that the average risk-taking over all banks is constant. Hence, changes in the average risk \({\overline{\sigma }_t}\) are attributed to changes in the exogenous riskiness of the banking business (“market risk”) and not to changes in the risk-taking behavior of banks.

  5. See Gordy and Howells (2006) for a similar idea of “counter-cyclical indexing”.

  6. Note that we derived (12) under the assumption of a zero intercept, while we allow for a non-zero intercept in the empirical assessment. However, in contrast to the relation of risk weights (11), the crucial relation (12) also holds in this setting, as we still have \(\beta _t = \beta _s\) for a fully cyclical standard and \(\beta _t = \frac{ \overline{\sigma }_s }{ \overline{\sigma }_t } \beta _s\) for a fully insensitive standard.

  7. We exclude banks with less than 10 yearly observations.

  8. Blundell-Wignall and Roulet (2013) and Mariathasan and Merrouche (2014) present similar RWD developments for different samples.

  9. This coincidence is a further indication that there is no severe endogeneity problem with our model, as Vallascas and Hagendorff (2013) come to very similar results by means of an instrumental variables regression.

  10. We utilize Model 2 and, to assess the level of the intercept and the slope of the curves, omit control variables.

  11. The leverage ratio is not indisputable. There is theoretical evidence that it may actually lead to higher risk-taking, see Burghof and Müller (2014).

  12. Since RWD is defined for book values, the calculation assumes a market-to-book ratio of 1.

  13. 53 % of the banks in our 2012 sample exhibit an asset volatility below 1.54 %, the intersection of the theoretical and empirical risk curves.

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Authors and Affiliations

  1. University of Hagen, Universitätsstr. 41, 58084, Hagen, Germany

    Rainer Baule

  2. Münster University of Applied Sciences, Corrensstr. 25, 48149, Münster, Germany

    Christian Tallau

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  1. Rainer Baule
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  2. Christian Tallau
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Correspondence to Rainer Baule.

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We thank two anonymous referees for valuable comments and suggestions. Financial support from TriSolutions GmbH is gratefully acknowledged.

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Baule, R., Tallau, C. Revisiting Basel risk weights: cross-sectional risk sensitivity and cyclicality. J Bus Econ 86, 905–931 (2016). https://doi.org/10.1007/s11573-016-0824-6

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