HEC Research Papers Series,
HEC Paris

Abstract: The regulatory use of banks' internal models makes capital requirements more risk-sensitive but invites regulatory arbitrage. I develop a framework to study bank regulation with strategic selection of risk models. A bank supervisor can discourage arbitrage by auditing risk models, and implements capital ratios less risk-sensitive than in the first-best to reduce auditing costs. The optimal capital ratios of a national supervisor can be different from those set by supranational authorities, in which case the supervisor optimally tolerates biased models. I discuss the empirical implications of this "hidden model" problem, and policy answers such as leverage ratios and more reliance on backtesting mechanisms.

Keywords: basel risk-weights; internal risk models; leverage ratio; supervisory audits

JEL-codes: D82; D84; G21; G32; G38

55 pages, First version: September 1, 2017. Revised: November 29, 2017.

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