Banks’ Optimal Implementation Strategies for a Risk Sensitive Regulatory Capital Rule: A Real Options and Signalling Approach

Abstract

I evaluate a bank's incentives to implement a risk sensitive regulatory capital rule and to invest in improved risk measurement. The decision making is analyzed within a real options framework where optimal policies are derived in terms of threshold levels of risk. I also evaluate the situation where exercise or non-exercise of the options to implement or invest are signals about the underlying quality of the loan portfolio. The framework is used for a numerical evaluation of banks' decision of whether to use internal rating based models for credit risk (the IRB-approach) under the new Basel accord (Basel II), where the dynamic behavior of risk is described by an Ohrnstein-Uhlenbeck process. I discuss empirical implications of the evaluation framework.