The regulatory use of banks' internal models makes capital requirements more risk-sensitive but invites regulatory … arbitrage. I develop a framework to study bank regulation with strategic selection of risk models. A bank supervisor can … discourage arbitrage by auditing risk models, and implements capital ratios less risk-sensitive than in the first-best to reduce …

Large banks assess their regulatory capital for market risk using complex, firm-wide Value-at-Risk (VaR) models. In … their 'bottom-up' approach to VaR there are many sources of model risk. A recent amendment to banking regulations requires … additional market risk capital to cover all these model risks but, as yet, there is no accepted framework for computing such an …