Risk Weights in Regulatory Capital Standards: Is It Necessary to "Get It Right"?

In recent decades, bank regulators have become increasingly reliant upon quantitative regulatory capital standards as a means of ensuring that banks hold adequate capital. The risk-based capital standards, from the 1988 Accord through the current Basel II standards, have primarily relied upon a building block approach to capital through the use of risk weights assigned to assets and off-balance sheet activities. Despite enhancements to improve the accuracy of risk-based capital standards, they continue to result in unintended consequences as the use of risk weights brings with it errors in the measurement of risk. Given the ongoing efforts by bank regulators to quantitatively assess risk, and correspondingly required capital, this study asks whether it is necessary for regulators to accurately assess risk weights in the risk-based capital standards. The simulation results suggest that, in order to minimize the unintended consequences associated with regulatory capital requirements, it is necessary for regulatory requirements to accurately mimic banks’ internal capital allocation processes.