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.

It is commonly believed that deposit rates are determined primarily by supply: Depositors require higher deposit rates from risky banks, thereby creating market discipline. An alternative perspective is that market discipline is limited (e.g., due to deposit insurance and/or enhanced capital regulation) and that internal demand for funding by banks determines rates. Using branch-level deposit rate data, we find little evidence for market discipline as rates are similar across bank capitalization levels. In contrast, banks’ loan growth has a causal effect on deposit rates; for example, branches’ deposit rates are correlated with loan growth in other states in which their bank has some presence, suggesting internal capital markets help reallocate the bank’s funding.