Banks’ internal models and RWA variability: strategic modelling and portfolio reallocation?

We analyse the effects of internal ratings-based (IRB) models on risk-weighted asset (RWA) variability, investment strategies and capital management among significant banks in the euro area, using a unique supervisory dataset. Our findings indicate a decline in RWA density (i.e. the ratio of risk-weighted assets to total exposure at default) following the adoption of internal models. The magnitude of this reduction varies across banks and is influenced by balance sheet characteristics. We find no evidence that, in the post-2015 SSM setting, weakly capitalized or fragile banks reduced RWA density more than other banks after the adoption of IRB models along the margins examined in the paper. This is consistent with the view that harmonized supervision may have limited the scope for opportunistic post-adoption reductions in RWAs. Finally, we provide evidence that IRB models encourage banks to reallocate credit towards more profitable assets – particularly those to large non-financial corporations – while reducing sovereign and central bank exposures.