Procyclicality and the new Basel Accord–banks’ choice of loan rating system

Catarineu-Rabell, Eva, Jackson, Patricia and Tsomocos, Dimitrios P. (2003) Procyclicality and the new Basel Accord–banks’ choice of loan rating system. Financial Markets Group Discussion Papers (464). Financial Markets Group, The London School of Economics and Political Science, London, UK.

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Abstract

The Basel Committee on Banking Supervision is proposing to introduce, in 2006, new risk-based requirements for internationally active (and other significant) banks. These will replace the relatively risk-invariant requirements in the current Accord. This article examines the implications of this new risk-based regime for procyclicality of minimum capital requirements – in particular whether the choice of particular loan rating system by the banks would significantly increase the likelihood of sharp increases in capital requirements in recessions, creating the potential for classic credit crunches. The paper finds that rating schemes that are designed to be more stable over the cycle, akin to those of the external rating agencies, would not increase procyclicality, but ratings that are conditioned on the current point in the cycle, akin in some respects to a Merton approach, could substantially increase procyclicality. This makes the question of which rating schemes banks will use very important. The paper uses a general equilibrium model of the financial system to explore whether banks would choose to use a countercyclical, procyclical or neutral rating scheme. The results indicate that banks would not choose a stable rating approach, which has important policy implications for the design of the Accord. It makes it important that banks are given incentives to adopt more stable rating schemes. This consideration has been reflected in the Committee’s latest proposals, in October 2002.

Item Type:	Monograph (Discussion Paper)
Official URL:	http://fmg.ac.uk
Additional Information:	© 2003 The Authors
Divisions:	Financial Markets Group
Subjects:	H Social Sciences > HG Finance H Social Sciences > HB Economic Theory
JEL classification:	G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
Date Deposited:	13 Aug 2009 14:22
Last Modified:	15 Sep 2023 22:55
URI:	http://eprints.lse.ac.uk/id/eprint/24863

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