Rainer Haselmann, Universität Frankfurt, The Limits of Model-Based Regulation

In this paper, we investigate how the introduction of complex, model-based capital regulation affected credit risk of financial institutions. We show that (1) internal risk estimates employed for regulatory purposes systematically underpredict actual default rates by 0.5 to 1 percentage points; (2) both default rates and loss rates are higher for loans that were originated under the model-based approach, while corresponding risk-weights are significantly lower; and (3) interest rates are higher for loans originated under the model-based approach.