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The authors wish to thank Charles Enoch, Huw Evans, Carl Lindgren, and Jan Willem van der Vossen for their valuable insights and comments. We also thank Anthony Saunders and Berry Wilson who provided data on capital ratios in Canada, the United Kingdom, and the United States.
The IMF Staff have submitted comments to the Committee on the proposed revisions to the capital adequacy framework. This paper, although not formally linked to the comments, aims to provide background to the comments and to discuss some of the key issues in greater depth.
The Mexican peso crisis in 1995 occurred shortly after Mexico had been admitted to OECD membership. The Republic of Korea is another example of a country suffering a severe financial crisis subsequent to being admitted to the OECD.
In fact, supervisory authorities in many countries, including Argentina, Bahrain, Brazil, Estonia, India, Hong Kong SAR, Kuwait, Latvia, Singapore, Thailand, and Uganda have implemented higher CARs ranging from 8.5 percent to 12 percent.
For example, the regulatory methodology is often written into formal regulations or legislation, which requires time to change.
See footnote 4 for examples of the countries that have adopted a higher standard.
A comparison of rating trends and spread trends (where spreads serve as a proxy for the market’s view of sovereign creditworthiness) for a set of “crisis” and “noncrisis” countries revealed that rating downgrades were much less severe than the surge in loss probabilities implied by the risk premia demanded by the market. (IMF, 1999, p. 221)
Currently the SEC regards five rating agencies as NRSROs for the purposes of the net capital rule (described below), including Standard & Poor’s, Moody’s, FitchIBCA, Duff & Phelps, and Thomson Bank Watch.
However, an earlier study by the same authors found that issuers rated near the investment-grade/speculative-grade border were more likely to request a third rating. Among those firms with split initial ratings (i.e., one investment-grade and one speculative-grade) that requested a third rating, 85 percent of them received a second investment-grade rating (Cantor and Packer, 1994).
The net capital rule (Rule 15c3-l) requires a broker dealer to reduce the value of the securities positions that it owns by specified percentages when calculating its capital. Broker-dealers that own commercial paper, nonconvertible debt securities, and nonconvertible preferred stock are allowed to reduce their haircuts for these instruments when computing capital if the instruments are rated investment grade by at least two NRSROs.
It is worth noting that the regulatory use of ratings more generally predates the SEC’s use of ratings and NRSROs designation. The first usage goes back to the 1930s, when the Office of the Comptroller of the Currency and the Federal Reserve Board restricted banks to investing in investment-grade securities. For a comprehensive list of the regulatory use of ratings in the United States and selected industrial and emerging economies, see IMF (1999).
Based on discussions with representative of the SEC.
Ideally, ratings would be “denominated” in implied loss rates, rather than default rates, but systematic data on recoveries is not available.
The Committee surveyed around 30 large, diversified, international banks, while the Federal Reserve study is based on the 50 largest banks in the United States. This section is largely based on the findings of these two surveys.
The specific issues raised by credit risk models are discussed in the next sub-section.
Specific factors reviewed in rating a facility include collateral taken, seniority, and other structural features.
Internal rating systems with a larger numbers of grades are more costly to operate, given the extra work required to distinguish finer degrees of risk. The majority of U.S. banks surveyed expressed an interest in increasing the number of grades, but among those that expressed such intentions, most of them had no active effort in progress (Carey and Treacy, 1998).
Relationship managers’ primary goal is to generate loan business at the highest possible risk-adjusted return on capital (RAROC). Therefore, they have an incentive to provide overly favorable credit assessments of their potential clients. By contrast, credit staff’s main responsibilities are to undertake risk analysis in the interest of managing the bank’s overall exposure and credit risk. As such, they are more independent.
In contrast to banks, external rating agencies have long time series on historical ratings and default rates, which banks frequently use in their models. However, the mapping of rating agency data to internal rating or credit model grades can lead to materially inaccurate estimates of default probabilities for internal grades.
Accordingly, technical assistance programs to build supervisory capacity may have to be adopted in several countries. Key elements of a capacity building program may include (a) a diagnostic assessment of the overall approach to supervision; (b) the implementation of a risk-based approach to onsite examination; (c) the design of early warning systems for effective offsite supervision; (d) rigorous follow-up on weaknesses identified onsite or offsite; and (e) the adoption of a comprehensive training program for the supervisory function.