Diminishing Risk-Weights Under the Basel II Accord: A Sign of Better Credit Quality or Regulatory Arbitrage?

Abstract: The Basel II-accord aimed to strengthen the financial system by making the banks more solvent. The Internal Ratings Based-model was introduced to create a better connection between risk held and regulatory capital. But during the last eight years, the average credit rating for the largest European banks has fallen to a level just three steps above speculative grade. This paper aims to study this anomaly. We have used data from 57 of the largest European banks and compared their risk-weights to market measures as well as accounting measures of credit risk. Our findings include statistically significant deviations in the relationship between risk-weights and credit risk. We argue that risk-weights do not reflect credit risk properly and that more advanced Internal Ratings Based-models systematically underestimate actual credit risk. Our arguments are founded on the deteriorating credit ratings of the European banks and their diminishing risk-weights. There is what appears to be a fundamental dichotomy between the banks' own perception of risk and that of the market.