Incentive-based Regulation of Banks: An Interpretation of Basel II

This paper models the incentives of banks to undertake "Regulatory Capital Ar-bitrage, " under the current capital requirements. I show that in equilibrium banks making risky investments pool with the banks investing safely so that they can be subject to a lower amount of regulatory capital because the risk exposures of banks cannot be precisely measured. The paper examines whether the proposed "Basel II " regulatory system would be more or less e ¢ cient and e¤ective than the current system. I show that the Internal Ratings-based (IRB) Approach of Basel II can be interpreted as a way of forcing a separating equilibrium, in which good banks that do not pursue unduly risky strategies identify themselves to the regulators and are rewarded with a lower capital requirement. Such a separating equilibrium can only be sustained under an e¤ective supervision system or by giving some incentives to the excessively risk-taking banks to stay in the current system rather than opting into the new IRB approach. *I especially thank the chairs of my committee, Stewart Myers and Steve Ross, for their encour-agement, guidance, and many helpful suggestions. I also gratefully acknowledge many conversations with Reto Gallati, Can Emre Koksal, and Antoinette Schoar. Many thanks are also due to Allen Berger, Bob Avery, Christa Bouwman, Paul Calem, Michael Gordy, Eric Heit\u85eld, and the seminar participants at the Board of Governors of the Federal Reserve System. All errors are the responsi-bility of the author