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The Basel Committee Approach To Risk-Weights And External Ratings: What Do We Learn From Bond Spreads?

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  • Andrea Resti

    ()
    (University of Milan L. Bocconi)

  • Andrea Sironi

    ()
    (University of Milan L. Bocconi)

Abstract

The Basel Committee for Banking Supervision designed a system of risk weights (the so called standardised approach) to measure the riskiness of banksÂ’ loan portfolios. Its ability to adequately reflect risk is empirically investigated in this paper, through an analysis of the economic capital allocations implied in corporate bond spreads. This is based on a unique dataset of issuance spreads, ratings and other relevant bond variables (such as maturity, face value, time of issuance and currency of denomination) including 7,232 eurobonds issued mostly by Canadian, European, Japanese and U.S. companies during 1991-2003. Three main results emerge. First, the spread/rating relationship is strongly significant with spreads increasing when ratings worsen. Second, the estimated spreads per rating class indicate that the risk/rating relationship might be steeper than the one approved by the Basel Committee. Finally the difference between the spread/rating relation of banks and non-financial firms appears quite blurred and statistically questionable. Following this empirical evidence, we underline some adjustments in the standardised approach risk-weights that might be considered for the future versions of the Basel Accord.

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Bibliographic Info

Paper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 548.

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Date of creation: Feb 2005
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Handle: RePEc:bdi:wptemi:td_548_05

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Keywords: eurobonds; credit ratings; spreads; capital regulation; banks.;

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  1. Eva Catarineu-Rabell & Patricia Jackson & Dimitrios P Tsomocos, 2003. "Procyclicality and the new Basel Accord - banks' choice of loan rating system," Bank of England working papers 181, Bank of England.
  2. Gordy, Michael B., 2000. "A comparative anatomy of credit risk models," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 119-149, January.
  3. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
  4. Diana Hancock & Myron L. Kwast, 2001. "Using subordinated debt to monitor bank holding companies: is it feasible?," Finance and Economics Discussion Series 2001-22, Board of Governors of the Federal Reserve System (U.S.).
  5. Altman, Edward I. & Saunders, Anthony, 2001. "An analysis and critique of the BIS proposal on capital adequacy and ratings," Journal of Banking & Finance, Elsevier, vol. 25(1), pages 25-46, January.
  6. Mark Carey, 1998. "Credit Risk in Private Debt Portfolios," Journal of Finance, American Finance Association, vol. 53(4), pages 1363-1387, 08.
  7. Arie Melnik & Doron Nissim, 2003. "Debt issue costs and issue characteristics in the Eurobond market," ICER Working Papers 09-2003, ICER - International Centre for Economic Research.
  8. Diana Hancock & Myron Kwast, 2001. "Using Subordinated Debt to Monitor Bank Holding Companies: Is it Feasible?," Journal of Financial Services Research, Springer, vol. 20(2), pages 147-187, October.
  9. Allen N. Berger & Richard J. Herring & Giorgio P. Szego, 1995. "The role of capital in financial institutions," Finance and Economics Discussion Series 95-23, Board of Governors of the Federal Reserve System (U.S.).
  10. Acharya, Viral V & Bharath, Sreedhar T & Srinivasan, Anand, 2003. "Understanding the Recovery Rates on Defaulted Securities," CEPR Discussion Papers 4098, C.E.P.R. Discussion Papers.
  11. Perraudin, William & Taylor, Alex P., 2004. "On the consistency of ratings and bond market yields," Journal of Banking & Finance, Elsevier, vol. 28(11), pages 2769-2788, November.
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Cited by:
  1. Abaffy, J. & Bertocchi, M. & Dupacova, J. & Moriggia, V. & Consigli, G., 2007. "Pricing nondiversifiable credit risk in the corporate Eurobond market," Journal of Banking & Finance, Elsevier, vol. 31(8), pages 2233-2263, August.
  2. International Monetary Fund, 2012. "Quantifying Structural Subsidy Values for Systemically Important Financial Institutions," IMF Working Papers 12/128, International Monetary Fund.
  3. Ueda, Kenichi & Weder di Mauro, B., 2013. "Quantifying structural subsidy values for systemically important financial institutions," Journal of Banking & Finance, Elsevier, vol. 37(10), pages 3830-3842.
  4. Fernando Gonzalez & François Haas & Ronald Johannes & Mattias Persson & Liliana Toledo & Roberto Violi & Martin Wieland & Carmen Zins, 2004. "Market dynamics associated with credit ratings - a literature review," Occasional Paper Series 16, European Central Bank.

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