Using historical data on sovereign and individual borrowers, the authors assess the potential impact on non-high-income countries of linking capital asset requirements for banks to private sector ratings, as the Basel committee has proposed. They show that linking bank's capital asset requirements to external ratings would have undesirable effects for developing countries. First, ratings of banks and corporations in developing countries are less common, so capital asset requirements would be practically insensitive to improvements in the quality of assets-widening the gap between banks of equal financial strength in higher- and lower-income countries. Second, bank and corporate ratings in developing countries (unlike their counterparts in high-income countries) are strongly linked to the sovereign ratings for the country-and appear to be strongly related (asymmetrically) to changes in the sovereign ratings. A sovereign downgrading would bring greater changes in capital allocations than an upgrading, and would call for larger capital requirements at the very time access to capital markets was more difficult. Under the new guidelines, capital requirements in developing countries would thus be exposed to the cyclical swings associated with the revision of sovereign ratings in recent crises. Ultimately, linking banks'capital asset requirements to private sector ratings would reduce the credit available to non-high-income countries and make it more costly, limiting economic activity. Bank capital needs in developing countries would be more volatile than those in high-income countries. These findings suggest that the Basel Committee should assess the role it proposes assigning to external ratings, to minimize the detrimental impact of the regulatory use of such ratings on developing countries.
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