Interest rate risk subsidization in international capital standards

Abstract

In setting capital standards on the basis of credit risk alone, the Basle Accord does not consider other types of risk such as interest rate risk. In this paper, we empirically investigate the impact of this implicit interest rate risk subsidy on bank risk-taking behavior. In the post-Accord period, we find that 20% of banks have excessive levels of on-balance sheet duration gaps which exceed 1% of total assets. Our empirical evidence supports an argument that banks have substituted unpriced interest rate risk for priced credit risk in their portfolios to take advantage of an interest rate risk subsidy under the Basle Accord. Banks which were exposed to significant levels of interest rate risk in the post-Accord period tend to be smaller, less active in off-balance sheet activities, have smaller credit risk exposure and higher risk-based capital ratios, but have lower capital to asset (leverage) ratios than other banks. Although the observed decline in credit risk and increase in interest rate risk may be the result of factors which have nothing to do with capital requirements, the magnitude of the shifts suggests the importance of pricing interest rate risk in risk-based capital regulations.