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

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. In this article the implications of this new risk-based regime for procyclicality of minimum capital requirements are examined - in particular, whether the choice of particular loan rating system by the banks would significantly increase the likelihood of sharp increases in capital requirements in recessions, creating the potential for classic credit crunches. It is found that rating schemes that are designed to be more stable over the cycle, akin to those of the external rating agencies, would not increase procyclicality, but ratings that are conditioned on the current point in the cycle, akin in some respects to a Merton approach, could substantially increase procyclicality. This makes the question of which rating schemes banks will use very important. A general equilibrium model of the financial system is used 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 Committees latest proposals, in October 2002.