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Perverse Effects of an External Ratings-Related Capital Adequacy System

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  • Patrick Honohan

Abstract

type="main" xml:lang="en"> 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)

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  • Patrick Honohan, 2001. "Perverse Effects of an External Ratings-Related Capital Adequacy System," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 30(3), pages 359-372, November.
    • Handle: RePEc:bla:ecnote:v:30:y:2001:i:3:p:359-372
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    File URL: http://hdl.handle.net/10.1111/1468-0300.00063
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    Cited by:

    1. Honohan, Patrick, 2008. "Risk Management and the Costs of the Banking Crisis," National Institute Economic Review, National Institute of Economic and Social Research, vol. 206, pages 15-24, October.
    2. Patrick Honohan, 2009. "Bank Failures: The Limitations of Risk Modeling," World Scientific Book Chapters, in: Douglas D Evanoff & Philipp Hartmann & George G Kaufman (ed.), The First Credit Market Turmoil Of The 21st Century Implications for Public Policy, chapter 8, pages 103-123, World Scientific Publishing Co. Pte. Ltd..

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