Banks' Internal Rating Models - Time for a Change? The "System of Floors" as Proposed by the Basel Committee

03-11-2016

This briefing paper reviews evidence showing that the adoption of an International Ratings Based (IRB) approach to estimating risk weights by banks has been associated with reductions in average reported risk weights. Several economic studies find that the lower reported risk weights using the IRB methodology to some extent reflect downward risk manipulation by banks. In a system of floors, the purpose of an aggregate output floor should be to prevent wholesale bank-level downward risk weight manipulation, giving rise to effective bank undercapitalization and a heightened probability of bank failure. Input floors can play a useful role alongside an aggregate output floor, if they are targeted to address the problem of potential mismeasurement of risk.

This briefing paper reviews evidence showing that the adoption of an International Ratings Based (IRB) approach to estimating risk weights by banks has been associated with reductions in average reported risk weights. Several economic studies find that the lower reported risk weights using the IRB methodology to some extent reflect downward risk manipulation by banks. In a system of floors, the purpose of an aggregate output floor should be to prevent wholesale bank-level downward risk weight manipulation, giving rise to effective bank undercapitalization and a heightened probability of bank failure. Input floors can play a useful role alongside an aggregate output floor, if they are targeted to address the problem of potential mismeasurement of risk.