Rational blinders : is it possible to regulate banks using their internal risk models ? ∗ Job Market Paper

Financial institutions use quantitative risk models not only to manage their risks, but also to communicate information. The Basel regulation in particular uses banks’ own estimates to make capital requirements more sensitive to each bank’s risks, and both the models and the regulation have been blamed for their over-optimism. I link over-optimism to a hidden information problem between a regulator and a bank who knows better which models are correct. If the regulator treats this problem as “model risk” and only uses tighter capital requirements (e.g. switches from Basel II to Basel III), a wider adoption of optimistic models to bypass the regulation and an increase of banks’ risk can follow. On the other hand, there is a cost of ensuring banks use adequate models, which increases with the extent to which internal models are used to compute finer capital requirements. Informational constraints thus make the case for a model-based regulation much weaker. More broadly, this paper shows how economic incentives can impact the development of new predictive models. Journal of Economic Literature Classification Number : D82, D84, G21, G32, G38.