XXVI Edition

14-15-16 December 2017"

IRB Model Regulatory Arbitrage and Profitability at European Banks

Ferri Giovanni, LUMSA University
Pesic Valerio, University La Sapienza of Rome

Internal Rating Based (IRB) models maneuvering evokes regulatory arbitrage allowing a bank to report Risk Weighted Assets (RWAs) below what reported by a similar bank not indulging in regulatory arbitrage. Focusing on profitability distortions in a large sample of European banks, we find that reporting RWAs below our model prediction Granger-causes higher profitability among banks using IRB-Advanced approaches. Our results stand up a battery of robustness checks. Thus, we conclude that regulatory arbitrage via IRB model calibration significantly affects reported profits at European banks. Authorities should either make IRB model validation more effective or consider phasing out IRB model discretion.

Area: Financial Regulation and Supervision

Keywords: Banking; Regulatory arbitrage; Profitability; Risk Weighted Assets dispersion; IRB

Paper file

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