The Manipulation of Basel Risk-Weights

This paper examines the relationship between banks’ approval for the internal ratings-based (IRB) approaches of Basel II and the ratio of risk-weighted over 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 is lower once regulatory approval is granted. The effect persists when we control for different loan categories, and we provide evidence showing that it cannot be explained by flawed modelling, or improved risk-measurement alone. Consistent with theories of risk-weight manipulation, the authors find the decline in risk-weights to be particularly prevalent among weakly capitalised banks, when the legal framework for supervision is weak, and in countries where supervisors are overseeing many IRB banks. They conclude that part of the decline in reported riskiness under the IRB results from banks’ strategic risk-modelling.