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Banks' Credit-Portfolio Choices and Risk-Based Capital Regulation

Nielsen, Caren Yinxia LU (2016) In Working Papers
Abstract
To address banks’ risk taking during the recent financial crisis, we develop a model of credit-portfolio optimization and study the impact of risk-based capital regulation (Basel Accords) on banks’ asset allocations. The model shows that, when a bank’s capital is constrained by regulation, regulatory cost (risk weightings in the Basel Accords) alters the risk and value calculations for the bank’s assets. The model predicts that the effect of a tightening of the capital requirements – for banks for which these requirements are (will become) binding – will be to skew the risky portfolio towards high-risk, high-earning assets (low-risk, low-earning assets), provided that the asset valuation – i.e., reward-to-regulatory-cost ratio – of the... (More)
To address banks’ risk taking during the recent financial crisis, we develop a model of credit-portfolio optimization and study the impact of risk-based capital regulation (Basel Accords) on banks’ asset allocations. The model shows that, when a bank’s capital is constrained by regulation, regulatory cost (risk weightings in the Basel Accords) alters the risk and value calculations for the bank’s assets. The model predicts that the effect of a tightening of the capital requirements – for banks for which these requirements are (will become) binding – will be to skew the risky portfolio towards high-risk, high-earning assets (low-risk, low-earning assets), provided that the asset valuation – i.e., reward-to-regulatory-cost ratio – of the high-risk asset is higher than that of the low-risk asset. Empirical examination of U.S. banks supports the predictions applicable to the dataset. In addition, our tests show the characteristics of banks with different levels of risk taking. In particular, the core banks that use the internal ratings-based approach under Basel II invest more in high-risk assets. (Less)
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author
organization
publishing date
type
Working Paper
publication status
published
subject
keywords
Banks , asset risk, credit risk , portfolio choice, risk-based capital regulation , G11 , G18, G21, G28
in
Working Papers
issue
2016:9
pages
33 pages
publisher
Department of Economics, Lund Universtiy
language
English
LU publication?
yes
id
6d3b5cbf-e278-4212-b311-7b117d46e503
alternative location
http://swopec.hhs.se/lunewp/abs/lunewp2016_009.htm
date added to LUP
2016-06-15 11:22:39
date last changed
2016-08-09 13:09:40
@misc{6d3b5cbf-e278-4212-b311-7b117d46e503,
  abstract     = {To address banks’ risk taking during the recent financial crisis, we develop a model of credit-portfolio optimization and study the impact of risk-based capital regulation (Basel Accords) on banks’ asset allocations. The model shows that, when a bank’s capital is constrained by regulation, regulatory cost (risk weightings in the Basel Accords) alters the risk and value calculations for the bank’s assets. The model predicts that the effect of a tightening of the capital requirements – for banks for which these requirements are (will become) binding – will be to skew the risky portfolio towards high-risk, high-earning assets (low-risk, low-earning assets), provided that the asset valuation – i.e., reward-to-regulatory-cost ratio – of the high-risk asset is higher than that of the low-risk asset. Empirical examination of U.S. banks supports the predictions applicable to the dataset. In addition, our tests show the characteristics of banks with different levels of risk taking. In particular, the core banks that use the internal ratings-based approach under Basel II invest more in high-risk assets.},
  author       = {Nielsen, Caren Yinxia},
  keyword      = {Banks ,asset risk,credit risk ,portfolio choice,risk-based capital regulation ,G11 ,G18,G21,G28},
  language     = {eng},
  note         = {Working Paper},
  number       = {2016:9},
  pages        = {33},
  publisher    = {Department of Economics, Lund Universtiy},
  series       = {Working Papers},
  title        = {Banks' Credit-Portfolio Choices and Risk-Based Capital Regulation},
  year         = {2016},
}