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Procyclicality and the new Basel Accord--banks' choice of loan rating system.

Article Excerpt
Summary. 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. The new requirements for the largest bank will be based on bank ratings of the probability of default of the borrowers. There is evidence that the choice of loan ratings which are conditional on the point in the economic cycle could lead to sharp increases in capital requirements in recessions. 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.

Keywords and Phrases: Basel Accord, Bank rating, Endogenous default, Procyclicality, Risk weights.

JEL Classification Numbers: D58, E44, G28.

1 Introduction

The Basel Committee on Banking Supervision is currently revising the minimum capital standards for internationally active banks in the G10, to introduce capital requirements which more closely reflect the risks. This offers economic benefits in reducing the possible distortions to the way that banking activity is conducted which can flow from risk-insensitive requirements. However, one unavoidable consequence of more risk-based requirements is that they could vary over the cycle, which could increase the likelihood that banks run-up against constraints on their lending in recessions.

Under Basel II, the capital requirements for the largest banks would be based on their current assessment of the probability of default of the borrower (ie rating)--Basel Committee of Banking Supervision (2003). There is a live policy debate over whether different rating approaches adopted by the banks would lead to different procyclical outcomes and if they did which approach banks would choose to adopt. We find that less forward-looking bank rating systems, conditioned on the point in the economic cycle, could lead to a substantial increase in capital requirements in recessions. Looking at the 1990-1992 recession, ratings based on a Merton-type model, which reflect the point in the cycle through the use of current liabilities, lead to a 40% to 50% increase in capital requirements. In contrast, Moody's ratings which are more forward looking, lead to little increase in capital requirements.

The paper uses a general equilibrium model to assess the costs/benefits for the banks of pursuing different approaches to setting ratings and therefore whether they would voluntarily choose to adopt a forward-looking approach which would give more stable ratings over the cycle. A parameterised version of Tsomocos (2003a,b) is used. The model includes heterogeneity of economic agents and endogenous default. By introducing capital charges (in the form of risk weights) for bank assets, which depend on the rating assigned by the bank which in turn depends on probability of default, we are able to assess the effect on bank profitability and welfare of the choice of different rating approaches.

1.1 Procylicality and the new Basel Accord

A long-standing concern with minimum prudential capital requirements for banks is that pressure on bank capital in a recession could lead to cutbacks in bank lending in stress periods. The introduction of the first Basel Accord in 1988 marked a worldwide adoption of minimum capital requirements that had to be met at all times. A number of academic studies were carried out after the recession in the early 1990s to see if the minimum standards had indeed created procyclical effects on lending by creating a credit crunch. This literature is surveyed in a study carried out by the Basel Committee on Banking Supervision (Jackson et al., 1999) and the conclusion for the United States was that particular sectors such as real estate or small businesses may have been affected by pressure on bank capital in some regions (Hancock and Wilcox, 1997, 1998; Peek and Rosengren, 1997a,b). But there was no evidence of widespread problems across the United States nor any clear-cut evidence for other countries.

The new Accord which will be introduced in 2006 could, however, have a profound effect on the dynamics of bank minimum capital and lending in recessions. In contrast to the current Accord where, for a given quantum of lending to a particular set of borrowers, the capital requirement is invariant over time, under the new Accord the capital requirements will depend on the current assessment of the probability of default (PD) of those borrowers. If borrowers are downgraded by a bank in a recession, then the capital requirements faced by the bank will rise. This would be in addition to the possible reduction in the bank's capital because of write-offs and specific provisions.

1.2 Bank ratings

Given the reliance on internal PD ratings under Basel II, an important question is the extent to which the rating approach chosen by a bank would affect the degree of procyclicality in the capital requirements. There is very little information available on the variation in internal bank ratings assigned to different borrowers over the cycle. One paper (Carling et al., 2001) examines ratings assigned by a Swedish bank to a group of borrowers over the period 1994 to 2000 and shows that they are not stable over time--there is considerable movement peak to trough. Segoviano and Lowe (2002) looking at Mexican bank ratings also find substantial swings.

Although there is little direct evidence on bank internal ratings there is evidence from other sources. There are two main types of rating approach used by the banks. Some banks have adopted rating systems which are modelled on the approach taken by the rating agencies, which is designed to give less variability in ratings if economic conditions change. The approach taken to the economic climate is clearly set out in the following comment by Standard and Poor's: 'Standard and Poor's credit ratings are meant to be forward looking; that is, their time horizon extends as far as is analytically foreseeable. Accordingly, the anticipated ups and down of business cycles--whether industry-specific or related to the general economy--should be factored into the credit rating all along' (4).

Many other banks have adopted an approach based on KMV which uses the current equity price of the borrower and current information on the borrower's liabilities to calculate a Merton default likelihood. Because these estimates use current liabilities of the borrower they may well show more variability as economic conditions change--with riskiness apparently increasing in the later stages of a boom (when indebtedness traditionally increases) and the subsequent downturn.

The question of the relative cyclicality of capital requirements according to whether internal ratings are based on (1) a rating industry approach or (2) a Merton-type model, is explored by taking different profiles of loan books across PD bands and applying recession ratings-transition matrices to produce a stressed quality distribution. The change in the capital requirements under the new Basel Accord can then be calculated...

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