The Implications of Partially Using Internal Risk Models: Evidence from European Panel Data

Abstract

In most countries, banks gradually rollout the internal ratings-based approach (IRBA) across credit risk exposures. My analysis reveals that some banks, called non-rollout banks, apply the IRBA only partially for several years and therefore are able to save implementation costs compared to rollout banks. Further, I find a non-monotonic relation between the IRBA coverage ratio and risk-weight densities: Banks firstly implement IRBA for those portfolios that promise the highest reduction in risk-weighted assets (RWA). Overall, the results suggest that non-rollout banks implement the IRBA (only) for exposures for which implementation costs are (over-) compensated by RWA savings. Moreover, I show that an incomplete rollout process is associated with a lower loan quality, which contradicts the purpose of policy makers to introduce internal models as a comprehensive risk governance tool.