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The Limits of Model‐Based Regulation
Author(s) -
BEHN MARKUS,
HASELMANN RAINER,
VIG VIKRANT
Publication year - 2022
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/jofi.13124
Subject(s) - capital requirement , capital (architecture) , asset (computer security) , capital adequacy ratio , loan , financial stability , bank regulation , monetary economics , business , economics , stability (learning theory) , actuarial science , finance , financial system , microeconomics , computer science , computer security , profit (economics) , archaeology , history , incentive , machine learning
Using loan‐level data from Germany, we investigate how the introduction of model‐based capital regulation affected banks' ability to absorb shocks. The objective of this regulation was to enhance financial stability by making capital requirements responsive to asset risk. Our evidence suggests that banks “optimized” model‐based regulation to lower their capital requirements. Banks systematically underreported risk, with underreporting more pronounced for banks with higher gains from it. Moreover, large banks benefitted from the regulation at the expense of smaller banks. Overall, our results suggest that sophisticated rules may have undesired effects if strategic misbehavior is difficult to detect.