Financial risk and capital adequacy: The moral hazard problem

Abstract

This paper estimates the values at risk for marketable assets in order to examine the propriety of the risk weights set by the Basel Accord and compare the capital charges between the standardised and the internal model approaches using the actual positions of institutions. The paper finds that the risk weights exhibit a risk-encouraging concave function of financial risk, and tend to favour risky assets over riskless assets. Such ‘supervisory discrimination’ in terms of risk weights gives rise to a moral hazard problem in that the regulator fails to reduce the risk-taking incentives of institutions. The internal model approach does not necessarily provide the capital savings to encourage institutions to develop internal models. As capital savings will occur only in the case of low-risk institutions, high-risk institutions, which need to introduce an internal model to improve their risk management, will choose the standardised method as their tool for calculating capital requirements.