Perverse Effects of an External Ratings‐Related Capital Adequacy System

Abstract

It has recently been proposed that banks should be allowed to hold less capital against loans to borrowers who have received a favourable rating by an approved external credit assessment institution (ECAI), or rating agency. But a plausible model of rating agency behaviour shows that this strategy could have perverse results, actually increasing the risk of deposit insurance outlays. First, there is an issue of signalling, whereby low‐ability borrowers may alter their behaviour so as to secure a lower capital requirement for their borrowing. Second, the establishment of 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, though it is these that cause the major bank failure costs.(J.E.L.:E53, G21, G33)