RISK-BASED CAPITAL STANDARDS AND THE RISKINESS OF BANK PORTFOLIOS - CREDIT AND FACTOR RISKS

Bank risk-based capital (RBC) standards require banks to hold differin g amounts of capital for different classes of assets, based almost ent irely on a credit risk criterion. This paper provides both a theoretic al and empirical framework for evaluating such standards. A model outl ining a pricing methodology for loans subject to default risk is prese nted. The model shows that the returns on such loans are affected by t he complicated interaction of the likelihood of default, the consequen ces of default, term structure variables, and the pricing of factor ri sks in the economy. When we examine whether the risk weights accuratel y reflect bank asset risk, we find that the weights fail even in their limited goal of correctly quantifying credit risk. For example, our f indings indicate that the RBC weights over-penalize home mortgages, wh ich have an average credit loss of 13 basis points, relative to commer cial and consumer loans. The RBC rules also contain a significant bias against direct mortgages relative to mortgage-backed securities. In a ddition, we find large differences in the credit riskiness of loans wi thin the 100% weight class and potentially large benefits to loan dive rsification, neither of which are considered in the RBC regulations. W e also examine other types of bank risk by estimating a simple factor model that decomposes loan risk into term structure, default, and mark et risk. One implication of our findings is that although banks have r eallocated their portfolios in ways intended by the RBC standards, the y may have merely substituted one type of risk (term structure risk) f or others (default and market risk), of which the net effect is unknow n.