Strategic Selection of Risk Models and Bank Capital Regulation∗

Using banks’ internal models for regulatory purposes, while aimed at making capital requirements more accurate, invites regulatory arbitrage. I develop a framework to study the strategic selection of risk models, and derive predictions in line with recent empirical evidence. I also study optimal regulations. Penalizing banks with low risk-weights when they suffer abnormal losses is a powerful tool, currently used for market risk models, but needs to be amended when model uncertainty bears on tail risks. Recent regulatory reforms using non-risk based ratios are counter-productive in this framework, because the issue is not model risk but a “hidden model” problem. Journal of Economic Literature Classification Number : D82, D84, G21, G32, G38.