The Role of Credit Ratings in Bank Capital

This paper examines two specific aspects of the Basel Committee’s proposed reforms to the 8% risk-based capital ratio. We argue that relying on “traditional” agency ratings could produce cyclically lagging rather than leading capital requirements, resulting in an enhanced rather than reduced degree of instability in the banking and financial system, the so-called “procyclicality” problem. Despite this possible shortcoming, we believe that sensible risk based weighting of capital requirements is a step in the right direction. The various standardized risk based bucketing proposals of June 1999 and January 2001, which are tied to external agency ratings, or possibly to internal bank ratings, however, lack a sufficient degree of granularity. In particular, we argue that in Basel’s first proposal of June, 1999, lumping A and BBB (investment grade corporate borrowers) together with BB and B (below investment grade borrowers) severely misprices risk within that bucket and calls, at a minimum, for that bucket to be split into two. After the revisions in early 2001, we acknowledge the improved risk bucket guidelines, but still conclude that several of the new rating categories carry underweighted capital requirements and that banks may continue to be motivated to skew their portfolios toward lower rated loans. We examine the default loss experience on corporate bonds for the period 1981–1999 and propose a revised weighting system which more closely resembles the actual loss experience on credit assets. Later tests include the heightened default experience in 2000.