Internal ratings, the business cycle and capital requirements: some evidence from an emerging market economy
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 in risk 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-based 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 might be amplified by developments in the banking industry.
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- Powell, Andrew, 2002. "A capital accord for emerging economies?," Policy Research Working Paper Series 2808, The World Bank.
- Nickell, Pamela & Perraudin, William & Varotto, Simone, 2000.
"Stability of rating transitions,"
Journal of Banking & Finance,
Elsevier, vol. 24(1-2), pages 203-227, January.
- Gabriele Galati & Kostas Tsatsaronis, 2001. "The impact of the euro on Europe's financial markets," BIS Working Papers 100, Bank for International Settlements.
- Con Keating & Hyun Song Shin & Charles Goodhart & Jon Danielsson, 2001. "An Academic Response to Basel II," FMG Special Papers sp130, Financial Markets Group.
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