Internally‐Assessed Bank Capital Requirements and Loan Portfolio Spreads
| Published date | 01 October 2023 |
| Author | Danilo V. Mascia |
| Date | 01 October 2023 |
| DOI | http://doi.org/10.1111/1467-8551.12708 |
British Journal of Management, Vol. 34, 2334–2353 (2023)
DOI: 10.1111/1467-8551.12708
Internally-Assessed Bank Capital
Requirements and Loan Portfolio Spreads
Danilo V. Mascia
International Banking Institute, Leeds University Business School, University of Leeds, Maurice Keyworth
Building, Leeds, LS2 9JT, UK
Corresponding author email: D.V.Mascia@leeds.ac.uk
How the choice of more risk-sensitive capital requirements by some banks inuences
average borrowing costs for their customers remains an open question. By exploiting
cross-country manually collected capital requirement data, we nd higher portfolio loan
spreads in banks that compute a larger share of these requirements for the loan portfolio
through internal rating-based (IRB) models. This result is driven by larger IRB adopters
operating in credit markets with low competition from banks computing capital require-
ments with the less risk-sensitive standardized models, by IRB adopters in creditmarkets
where borrowers have more limited funding opportunities, and by IRB adopters in mar-
kets characterized by lower levels of political connectedness. Our results contrast with
theoretical predictions suggesting that the heterogeneity in risk weights induced by IRB
models should reduce average borrowingcosts for bank customers. Instead, we show that
IRB adopters do not fully incorporate the decrease in capital requirements obtained with
these models into their pricing policies when competitive and political pressures arelow.
Introduction
It is a widely held view that the level of riski-
ness underlying managerialdecisionswill affect the
realized protability (Delis, Hasan and Tsionas,
2015). In the context of banks, managerial deci-
sions are inuenced, among other things, by the
applicable capital regulation (Ayadi et al., 2021).
Depending on how risk-sensitive the regulatory
framework is, bank managers might apply differ-
ent business strategies,possibly achieving different
performance outcomes (Nguyen, Nguyen and Sila,
2019). With this paper, we are the rst to uncover
how the use of more sensitive methodologies to
assess credit risk, by some banks, inuences their
lending spreads, and how this relationship varies
depending on the type of banking system and the
level of political connectedness.
The presence of regulations that link bank cap-
ital to lending risk with the purpose of ensuring
bank stability is a key peculiarity of the bank-
ing industry (Berger and Bouwman, 2013). Since
the adoption in 2006 of the revised regulatory
framework known as Basel II, banks can use in-
ternal rating-based (IRB) models to quantify their
capital requirements for the loan portfolio. With
these models, banks estimate the probability of
default (PD) of each borrower and, often, other
credit risk parameters.1
The general consensus emerging from previous
studies is that IRB models reduce the capital
requirements of a bank and increase the hetero-
geneity of the requirements that a bank applies
across different borrowers (Abbassi and Schmidt,
2018; Behn, Haselmann and Wachtel, 2016;
Benetton, 2021; Glancy and Kurtzman, 2022;
Plosser and Santos, 2018). Theoretical studies
suggest that we should then potentially observe
a decrease in the loan portfolio spread of banks
opting for IRB models (Repullo and Suarez,2004;
Ruthenberg and Landskroner, 2008). This de-
crease materializes if the heterogeneity in capital
requirements generated by IRB models (namely,
1We provide an extensive institutional background in
Section A of the Online Appendix.
© 2023 The Author.British Journal of Management published by John Wiley & Sons Ltd on behalf ofBritish Academy
of Management.
This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs Li-
cense, which permits use and distribution in any medium, provided the original work is properly cited, the use is non-
commercial and no modications or adaptations are made.
Internally-Assessed Bank Capital Requirements and Loan Portfolio Spreads2335
penalizing riskier borrowers and rewarding safer
ones) is properly priced in lending contracts and
if competitors in the credit market employ the less
risk-sensitive standardized approach to quantify
capital requirements. Ultimately, a bank’s average
margins should decrease with the use of IRB mod-
els, signalling a reduction in average borrowing
costs (Repullo and Suarez, 2004).
In this paper we test the empirical validity of
the above theoretical arguments. To this end, we
offer the rst analysis on how IRB models are
associated with the spread of the loan portfolio
of IRB adopters relative to non-adopting banks
and document how this association is inuenced
by the competitive pressure from standardized
banks, by the type of lending relationship and by
the level of political connectedness.2Our study
enhances, therefore, our understanding of whether
IRB models matter for bank performance and of
the potential business consequences of regulatory
restrictions introduced from 2022 on their use (see
Basel Committee on Banking Supervision, 2017;
EBA, 2019; Federal Register, 2014).
We conduct our analysis using a unique cross-
country dataset covering the period from 1992 to
2016, including 2,191 banks located in 40 high-
income countries. From the year of the adoption
of Basel II in each country, and for each bank, we
manuallycollectinformation on the use of the IRB
approach and measure the relative importance of
this approach in quantifying a bank’s capital
requirements for credit risk. Therefore, differ-
ently from previous cross-country studies on IRB
adopters (Beltratti and Paladino, 2016; Cucinelli
et al., 2018; Mariathasan and Merrouche, 2014;
Vallascas and Hagendorff, 2013), our focus is
on measuring the share of risk-weighted assets
(RWAs) of credit exposures computed using IRB
models (over the total RWAs for credit risk, which
can be computed using both the standardized
approach and the IRB methodologies). We term
this ratio ‘IRB Intensity’ and use it to capturehow
intensively our sampled banks employ IRB models
to quantify the credit risk used to comply with
regulatory objectives.
2Weuse the phrase ‘standardized banks’ or ‘SA adopters’
to indicate banks exclusively adopting the standardized
approach (SA) to quantify the capital requirements for
credit risk. Those adopting (at least in part) IRB models
are termed ‘IRB adopters’ or ‘IRB banks’.
In the theoretical arguments that postulate
an impact of IRB models on the loan portfolio
spread, high-risk borrowers should avoid credit
relationships with IRB banks, as they can obtain
cheaper credit from standardized banks, while
safer borrowers would obtain cheaper funding
from IRB banks compared to the previous reg-
ulatory regime. From this perspective, we should
empirically observe lower capital requirements
for IRB banks compared to Basel I and an im-
provement of the quality of their loan portfolio.
Examining if this is the case in our sample, we
document that IRB models indeed reduce capital
requirements, but we only nd partial evidence
indicating that this effect is associated with an
improvement in loan portfolio quality.
We next move to our main focus and examine
whether the reduced capital requirementsachieved
by IRB banks decrease the loan portfolio spread
because of lower average borrowing costs for bank
customers. We estimate panel data models based
on conventional analyses on the determinants of a
bank’s loan portfolio spread (dened as in Abedi-
far,Molyneux and Tarazi, 2018), with the addition
of our measure ofhow much banks intensively
employ IRB models. Against the theoretical pri-
ors discussed previously, we nd that as banks
rely more heavily on IRB models to compute the
capital requirements for credit risk, the spread of
the loan portfolio increases and does not decrease.
Our key conclusion holds under a number of
alternative settings and is robust to endogeneity.
We then provide several tests to understand the
rationale behind the positive association between
spread and IRB Intensity.
Overall, our empirical ndings reveal that the
introduction of more risk-sensitive capital require-
ments has affected banks’ business management,
with a consequent improvement of banks’ lending
spreads as banks rely more heavily on IRB models
for regulatory purposes. The signicant reduction
of capital requirements for IRB adopters could
potentially be due to a strategic use of risk-based
models, namely IRB banks underestimating their
risk exposures in an attempt to save capital (Be-
gley, Purnanandam and Zheng, 2017; Colliard,
2019). Although theenhancement ofbanks’ prof-
itability is usually desirable from a regulatory
standpoint (being suggestive of bank viability),
if this is achieved via risk under-reporting, then
our results are supportive of regulatory inter-
ventions aimed at mitigating banks’ discretion in
© 2023 The Author.British Journal ofManagement published by John Wiley & Sons Ltd on behalf of British
Academy of Management.
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