Perverse effects of a ratings-related capital adequacy system
World Bank, Policy Research Dissemination Center, 2000 - Business & Economics - 14 pages
It is important to harness market information to improve bank safety (for example, by increasing the role of large, well-informed, but uninsured claimants) but the approach of a ratings-related capital adequacy system could be counterproductive. Relying on ratings could induce borrowers to increase their exposure to systemic risk even if they reduce exposure to specific risk.
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ability borrower chooses actually reduce amount of risk assume average default bank failure Basel capital ratio choose high risk cost credibility cut-off may actually debt contract default percentage default probability depends deposit insurance fund deposit insurance outlays efficient capital requirement equilibrium contract expected return favorable rating free entry high ability borrowers high capital high systemic risk higher hold less capital incentive structure induce low ability information made available interior solution loan contract low ability borrowers low ability entrepreneurs low capital low-ability lower capital requirement mean failure rate minimum capital no-profit condition payout Perverse Effects perverse results Policy Research rated borrowers rated firms rated securities rating agencies mediate ratings-related capital requirements received a favorable regulatory capital regulatory cut-off repayment contract Research Working Paper risk choices risk information risk level risk of default safety condition F satisfy Section specific risk standard deviation systematically biased type H unconditional default