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Perverse effects of a ratings-related capital adequacy system

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  • Honohan, Patrick

Abstract

It has recently been proposed that banks be allowed to hold less capital against loans to borrowers who have received a favorable rating by an approved rating agency. But a plausible model of rating-agency behavior shows that this strategy could have perverse results, actually increasing the risk of deposit insurance outlays. First, there is an issue of signaling, with low-ability borrowers possibly altering their behavior to secure a lower capital requirement for their borrowing. Second, establishing a regulatory cut-off may actually reduce the amount of risk information made available by raters. Besides, the credibility of rating agencies may not be damaged by neglect of the risk of unusual systemic shocks, although deposit insurers greatest outlays come chiefly at times of systemic crisis. And using agencies'individual ratings is unlikely to be an effective early-warning system for the risk of systemic failure, so use of the ratings could lull policymakers into a false sense of security. It is important to harness market information to improve bank safety (for example, by increasing the role of large, well-informed, but uninsured claimants), but this particular approach could be counterproductive. Relying on ratings could induce borrowers to increase their exposure to systemic risk even if they reduce exposure to specific risk.

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Bibliographic Info

Paper provided by The World Bank in its series Policy Research Working Paper Series with number 2364.

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Date of creation: 30 Jun 2000
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Handle: RePEc:wbk:wbrwps:2364

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Related research

Keywords: Banking Law; Banks&Banking Reform; Payment Systems&Infrastructure; Financial Intermediation; International Terrorism&Counterterrorism; Banks&Banking Reform; Financial Intermediation; Banking Law; Environmental Economics&Policies; Insurance&Risk Mitigation;

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  1. Gerard Caprio, Jr. and Patrick Honohan, 2008. "Banking Crises," The Institute for International Integration Studies Discussion Paper Series iiisdp242, IIIS.
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Cited by:
  1. Lakshman Alles, 2001. "Asset Securitization and Structured Financing," IMF Working Papers 01/147, International Monetary Fund.
  2. Demirgüç-Kunt, A. & Beck, T.H.L. & Honohan, P., 2008. "Finance for all?: Policies and pitfalls in expanding access," Open Access publications from Tilburg University urn:nbn:nl:ui:12-3508393, Tilburg University.

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