The new Basle Accord, internal ratings, and the incentives of banks

The Basle Accord of 1988 regulates how much equity banks must set aside as a cushion against the default risk. In its 1999 proposal for a new Accord, the Basle Committee seeks to introduce different equity ratios for customers of different risk levels. The proposal strongly favors external ratings a...

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Bibliographic Details
Published in:International review of law and economics 2002-05, Vol.21 (4), p.393-412
Main Author: Kirstein, Roland
Format: Article
Language:English
Subjects:
Bank loans
Bank operations
Banking
Banking industry
Banks
Basle Accord
Capital requirements
Credit risk
Equity
International finance
Law
Loans
Mathematical models
Ratings & rankings
Regulation
Risk assessment
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Summary:The Basle Accord of 1988 regulates how much equity banks must set aside as a cushion against the default risk. In its 1999 proposal for a new Accord, the Basle Committee seeks to introduce different equity ratios for customers of different risk levels. The proposal strongly favors external ratings as a means of risk determination. German banks, on the other hand, demand acknowledgement of their internal ratings. This paper shows that, even if assured that banks have better diagnosis skills that external ratings agencies, external ratings are better able to implement the goals of the Basle Committee than internal ratings. This is due to a lack of incentives to truthfully reveal their diagnosis results. These incentives may be provided by supervision of internal ratings, even if imperfect and only occasional. However, this requires that a fine be imposed if the supervising authority comes to a result different from the internal ratings assigned by the bank.
ISSN:0144-8188
1873-6394
DOI:10.1016/s0144-8188(01)00077-1