Comments on “Credit ratings and the BIS capital adequacy reform agenda”

Abstract

The New Basel Capital Accord (Basel Committee on Banking Supervision, 1999) has the objective of making capital requirements ‘‘appropriately sensitive to the degree of risk in bank activities’’. This is important because the original Capital Accord (1998) has been widely criticized for the lack of risk sensitivity of the capital charges assessed against various types of loans. Many observers believe this has resulted in regulatory arbitrage on the part of banks, to the detriment of the quality of the assets banks hold on their books. The Basel Committee has proposed a standardized approach for determining risk-based capital using external ratings and two other approaches based on internal models for dealing with credit risk. 1 Altman et al. (2002) examines in detail whether the goal of ‘‘appropriate risk sensitivity’’ is met by the proposed risk weights of the standardized approach. The main conclusion of the Altman et al. paper and the underlying issues can be seen in Fig. 1, which plots the proposed risk weights and the historical (corporate bond) losses by rating. As the authors note, ratings Aaa through A have experienced virtually no defaults but are assigned weights of 20 (Aaa and Aa) and 50 (A) percent. More problematic, the proposed risk weights for Baa and Ba rated loans are both 100%, even though the loss experience for Ba is 10 times higher than for Baa. Finally, the B and below rated loans have risk weights only half-again as large as Baa rated loans, while the historical loss experience has been 55 times greater! Thus, the Basel proposal fails to capture the relative risks of the various ratings. Altman et al. Journal of Banking & Finance 26 (2002) 923–928