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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.

Suggested Citation

  • Honohan, Patrick, 2000. "Perverse effects of a ratings-related capital adequacy system," Policy Research Working Paper Series 2364, The World Bank.
  • Handle: RePEc:wbk:wbrwps:2364
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    References listed on IDEAS

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    1. Gerard Caprio & Patrick Honohan, 2008. "Banking Crises," Center for Development Economics 2008-09, Department of Economics, Williams College.
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    Cited by:

    1. Lakshman Alles, 2001. "Asset Securitization and Structured Financing; Future Prospects and Challenges for Countries in Emerging Markets," IMF Working Papers 01/147, International Monetary Fund.

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