How Do Investors Prefer Banks to Transit to Basel Internal Models: Mandatorily or Voluntarily?

The recently finalized Basel Framework continues allowing banks to use internal data and models to define risk estimates and use them for the capital adequacy ratio computation. World-wide there are above two thousand banks running the Basel internal models. However, there are countries that have none of such banks. For them there exists a dilemma. Namely, which transition path to adopt out of the two. The voluntarily one as in the EU or the mandatory one as in the US. Our objective is to take the investor perspective and benchmark those two modes. Thus, we wish to find whether there is a premium for any of them, or perhaps that they are equivalent. The novelty of our research is the robust estimate that investors prefer mandatory transition style to the voluntarily one. Such a preference is reflected in the rise of the mean return and decline in stock volatility for the transited banks in the US and right the opposite consequences in the EU. However, we should be cautious in interpreting our findings. Such a preference may not only be the premium for the breakage of the vicious cycle and the ultimate improvement in the banks’ risk-management systems and the overall financial stability. It may also hold true if and only if the mandatory transition for particular institutions is accompanied by a restriction for other banks in the region to transit. Our findings are of value primarily to the emerging economies like Argentine and Indonesia.

How Do Investors Prefer Banks to Transit to Basel Internal Models: Mandatorily or Voluntarily?