The Risk Sensitivity of Capital Requirements: Evidence from an International Sample of Large Banks*

Abstract Using an international sample of large banks between 2000 and 2010, we evaluate the risk sensitivity of minimum capital requirements. Our results show that risk-weighted assets (the regulatory measure of portfolio risk, which determines minimum capital requirements) are ill-calibrated to a market measure of bank portfolio risk. We show that this low-risk sensitivity of capital requirements permits banks to build up capital buffers by underreporting their portfolio risk and undermines banks’ ability to withstand adverse shocks. While the risk sensitivity of capital requirements is higher for banks that have adopted Basel II, it remains low across banks and countries.