Working Paper: NBER ID: w7629
Authors: Mark Carey
Abstract: Now in prospect is a major revision of international bank capital regulations that would embody recent advances in credit risk measurement and management. Previous regulations have been simpler in structure, with a primary goal of getting capital requirements right on average, and thus have largely ignored the difference between average and marginal. This paper presents evidence that explicit treatment in new regulations of several important dimensions of credit risk is necessary. If such dimensions are compressed or ignored, capital arbitrage activities by banks are likely to continue, leading to an increase in bank failure rates over time.
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Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Regulatory capital treatment of assets with varying contributions to portfolio credit risk (G32) | Capital arbitrage activities by banks (G21) |
| Properly configured internal ratings approach (G24) | Reasonable approximations of economic capital allocations (G11) |
| Ignoring important dimensions of credit risk (G32) | Increased bank failure rates (G21) |
| Factors such as borrower default ratings, loss given default (LGD), and portfolio size (G33) | Significant differences in required capital (G32) |