Internal Rating Based Model, Bank Regulatory Arbitrage and Eurozone Crisis

I investigate how the complicated model-based capital regulation can be misused by European banks for capital saving purposes. I find that relative to banks from core countries, banks from peripheral countries (1) can greatly reduce the risk-weight associated with their assets by applying more internal rating-based (IRB) approach, and (2) the default frequency of their assets is not reflected in the risk-weight. On the other hand, peripheral banks (3) use less IRB approach, especially regarding exposure of the public sector. These results indicate that banks from peripheral countries are more likely to abuse the model-based capital regulation, by both strategically manipulating the risk-weights under the IRB models and avoiding IRB approach on certain exposures. Those findings support the concerns raised in the recent regulatory proposal (EBA 2016). In particular, not only the use of IRB should be carefully granted and closely supervised, but also the (permanent) partial use of IRB should be limited, so that both strategic IRB modelling and the so-called cherry-picking can be properly confined. JEL Classification: G01, G21, G28