Strategic Selection of Risk Models and Bank Capital Regulation

Description

This article published by Jean-Edouard Colliard in Journal of Economic Literature looked at 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. Penalty mechanisms can implement the first-best, but are less useful when model uncertainty bears on tail risks. In this case, the bank supervisor has to audit risk models, and optimally makes capital ratios less risk-sensitive to reduce auditing costs. If capital ratios are set by the Basel guidelines, the supervisor tolerates biased models. I discuss the empirical implications of this “hidden model” problem, and policy answers such as leverage ratios. The paper was background reading for the 2017 Public Economics Winter School.