IMFS Visiting Scholar Vikrant Vig about banking regulation and the size of banks

In an interview in the Annual Report of the IMFS Vikrant Vig, currently Visiting Scholar of Financial Economics, illustrates how banking regulation affects financial stability and what this means regarding the size of banks.

IMFS Visiting Scholar Vikrant Vig
“Our findings have important policy implications”

As an expert for corporate finance, law and finance and banking, Vikrant Vig, Visiting Scholar at the IMFS, investigated together with his co-authors Markus Behn and Rainer Haselmann how model-based regulation affects the stability of the financial sector. The paper has been published as IMFS Working Paper No. 82 “The Limits of Model-Based Regulation”

How would you describe the situation your paper takes up?

Following the financial crisis of 2008, policy makers around the world have concentrated their efforts on designing a regulatory framework that increases the safety of individual institutions as well as the stability of the financial system as a whole. In this context, an important innovation has been the introduction of complex, model-based capital  regulation  that  was meant to promote the adoption of stronger risk management practices by financial intermediaries, and – ultimately – to increase the stability of the banking system as defined by the Basel Committee on Banking Supervision in 2006.

In this paper, we examine how the introduction of model-based capital regulation affected the measurement and the overall level of banks’ credit risk. Prior to the introduction of model-based regulation, the regulatory environment was considered to be too coarse, leading to excessive distortions in lending. In contrast, regulation under Basel II relies on a complex array of risk models, designed and calibrated by banks themselves and subsequently approved by the supervisor. By tying capital charges to actual asset risk, banks are no longer penalized for holding very safe assets on their balance sheets, so that the distortion in the allocation of credit that accompanied the simple flat tax feature of Basel I is eliminated. However, given the wide prevalence of informational and enforcement constraints in the lending process, the effect of sophisticated, model-based regulation on banks’ credit risk remains an open question.

What was the most surprising outcome of the study?

To study this question, we exploit the institutional details of the German Basel II introduction in 2007, as well as the high granularity of our loan-level data set obtained from Deutsche Bundesbank. Following the reform, banks were allowed to choose between the model-based approach (referred to as the internal ratings-based approach, shortened to IRB) in which capital charges depend on internal risk estimates of the bank, and a more traditional approach that does not rely on internal risk parameters (referred to as the standard approach, shortened to SA). Importantly, among those banks that opted for the new approach, the so-called IRB banks, the introduction of the model-based approach was staggered over time. Risk models were certified by the supervisor on a portfolio basis, and supervisors delayed the approval of each model until they felt comfortable about the reliability of the model.

Now comes the interesting or the surprising part. At the aggregate level, we find that reported probabilities of default (PDs) and risk-weights are significantly lower for portfolios that were already shifted to the IRB approach compared with SA portfolios still waiting for approval. In stark contrast, however, ex-post default and loss rates go in the opposite direction – actual default rates and loan losses are significantly higher in the IRB pool compared with the SA pool. We also examine the interest rate that banks charge on these loans, as interest rates give us an opportunity to assess the perceived riskiness of these loans. Interest rates in the IRB pool are significantly higher than in the SA pool, suggesting that banks were aware of the inherent riskiness of these loan portfolios, even though reported PDs and risk- weights did not reflect this. These results are present in every year until the end of the sample period in 2012 and are quite stable across the business cycle.

Which consequences would you draw from your analysis regarding the banks and their size?

The high compliance costs associated with the model-based approach meant that only the larger banks adopted it. These large banks benefited from the new regulation and expanded their lending, potentially at the expense of smaller banks. Specifically, we find that banks that opted for the introduction of the model-based approach experienced a reduction in capital charges and consequently increased their lending by about 9 percent relative to banks that remained under the traditional approach. Thus, this complex, model-based regulation created barriers to entry and subsidized larger banks. This seems rather paradoxical, given the systemic risk associated with larger banks.

What do your findings imply for banking regulation?

Our findings have important policy implications. As a response to the financial crisis in 2007-08, the Basel Committee has drafted a third revision of the regulatory framework for banks, which is Basel III. This framework continues to rely on model-based regulation, but further increases complexity to address substantial weaknesses of the old framework. While the measures might make sense individually, our results suggest that further increases in complexity are unlikely to increase financial stability. The evidence presented in this paper provides support for the view that simpler and more transparent rules would be more effective in achieving the ultimate goal of financial stability.

To the IMFS Working Paper No. 82 "The Limits of Model-Based Regulation" (PDF)