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Internal ratings, the business cycle, and capital requirements: some evidence from an emerging market economy

  • Miguel Angel Segoviano
  • Philip Lowe
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    The concept of risk-based capital requirements enjoys widespread support. Effective implementation, however, requires that risk be measured accurately both across borrowers and across time. Under the New Capital Accord, the cornerstone of this risk measurement process is the rating of the borrower. In this paper we use the ratings assigned by individual Mexican banks to examine how measured credit risk for these banks has changed since the financial crisis in the mid 1990s. We then examine the implications of these changes for regulatory capital under the proposed changes to the Basel Capital Accord. We find that measured risk increased after the crisis and then fell as the recovery took hold. In turn, despite the limitations of the data, we find that the proposed internal ratings approach would have generated large swings in regulatory capital requirements over the second half of the 1990s, with required capital increasing significantly in the aftermath of the crisis, and then falling as the economy recovered. Looking forward, if movements in actual bank capital were to show this same cyclical variation, then business cycle fluctuations may be amplified by developments in the banking industry.

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    File URL: http://www.bostonfed.org/bankinfo/conevent/slowdown/segoviano_lowe.pdf
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    Article provided by Federal Reserve Bank of Boston in its journal Conference Series ; [Proceedings].

    Volume (Year): (2002)
    Issue (Month): ()
    Pages:

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    Handle: RePEc:fip:fedbcp:y:2002:x:7
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    1. Edward I. Altman & Andrea Resti & Andrea Sironi, 2002. "The link between default and recovery rates: effects on the procyclicality of regulatory capital ratios," BIS Working Papers 113, Bank for International Settlements.
    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. Powell, Andrew, 2002. "A capital accord for emerging economies?," Policy Research Working Paper Series 2808, The World Bank.
    4. Anil Bangia & Francis X. Diebold & Til Schuermann, 2000. "Ratings Migration and the Business Cycle, With Application to Credit Portfolio Stress Testing," Center for Financial Institutions Working Papers 00-26, Wharton School Center for Financial Institutions, University of Pennsylvania.
    5. Joe Peek & Eric S. Rosengren, 1997. "Collateral damage: effects of the Japanese real estate collapse on credit availability and real activity in the United States," Working Papers 97-5, Federal Reserve Bank of Boston.
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