Do banks’ internal Basel risk estimates reflect risk?

• We study risk alignment under the advanced internal-ratings-based approach (AIRB).
• We find AIRB risk weights are strongly aligned with loan performance.
• Risk weight alignment with external market based risk indicators is less strong.
• The risk-weight alignment of Basel AIRB banks is improved relative to Basel I.
• The choice of risk-weight measures matters in assessing alignment.

Using supervisory data for U.S. banks, we evaluate the alignment of Basel II/III AIRB (advanced internal ratings based) risk estimates with portfolio risk. We use loan performance as a direct measure of portfolio risk as well as less direct market-based measures. Our results document that AIRB risk weights are highly correlated with loan performance and that, in contrast, Basel I risk weights are not. We find that capital requirements under the AIRB approach are higher than those under Basel I especially for portfolios recently under stress such as mortgages and some sovereign exposures. The alignment of Basel risk estimates with market-based risk indicators is less robust, although the association is nevertheless stronger under the AIRB approach. Our results support the view that internally generated risk weights are determined mostly by portfolio risk and, as a result, are substantially more risk sensitive than the fixed asset class based risk weights of Basel I.