A Model Case for Simplification in Europe : Internal Ratings, Better Calibrated

Overview & Synopsis

The Internal Ratings-Based (IRB) modeling framework, introduced under Basel II, was designed to align capital requirements with measured credit risk by allowing banks to estimate their own probabilities of default, loss given default, and exposure at default. Two decades of experience have revealed a structural flaw in this design: banks that estimate the parameters governing their own capital charges face a permanent incentive to underestimate risk, and the supervisory apparatus built to contain this incentive has grown into one of the most complex and costly layers of European banking regulation. This paper proposes an alternative in which the regulator calibrates the credit risk models based on banks’ loan-level data. The proposal preserves the Basel risk weight function, the 99.9 percent confidence level, and bank-specific through-the-cycle calibration, while removing the structural incentive to underestimate risk that has driven two decades of regulatory escalation. Against five alternative reform paths, ranging from the incremental simplification pursued by European institutions to a binding leverage ratio, the proposal is the only one that combines risk sensitivity, cross-bank comparability, and cost efficiency within the boundaries of the Basel framework. The resulting simplification is substantial, with minimal impact on the level and risk-sensitivity of capital requirements