Do European banks manipulate risk weights?

Exploiting the information provided by the 2014 Comprehensive Assessment of the European Central Bank and the European Banking Authority, we provide new evidence on the manipulation of risk weights by banks. Concentrating our attention on credit risk density (non-defaulted risk weighted loans over non-defaulted loans), we confirm that the internal rate based approach (mostly the advanced) is used by banks to manipulate risk weights. Moreover, we find that risk weights are mostly underestimated in case of loans in the domestic market and in case of loans to the corporate and retail sectors-i.e. when asymmetric information is significant. We also show that the attitude to underestimation of risk weights is not due to incorrect assumptions of banks' models. Our evidence supports the hypothesis that national supervisory authorities are captured by local banks.