Abstract
In recent decades, bank regulators in both the U.S. and abroad, have become increasingly reliant upon quantitative regulatory capital standards that attempt to incorporate risk into banks’ minimum capital ratios. These risk-based standards often take a formulaic approach to capital requirements through the use of risk weights differentiated by the amount of credit risk in banks’ assets and off-balance sheet activities. Despite enhancements to the risk-based capital standards, they continue to contain errors that can significantly alter banks’ asset allocation as well as the amount of capital banks hold. Given the current emphasis by regulators on quantitatively assessing risk, this study asks whether it is necessary for regulators to accurately establish risk weights in the risk-based standards. Simulations suggest that the distorting effects of errors in the risk weights can be minimized by regulators altering minimum capital ratios applied to banks.