Internal ratings, the business cycle and capital requirements: some evidence from an emerging market economy
BIS Working Papers
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No
117
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02 September 2002
The concept of risk-based capital requirements enjoys widespread support.
Effective implementation, however, requires that risk be measured accurately
both across borrowers and across time. Under the New Capital Accord, the
cornerstone of this risk measurement process is the rating of the borrower. In
this paper we use the ratings assigned by individual Mexican banks to examine
how measured credit risk for these banks has changed since the financial crisis
in the mid-1990s. We then examine the implications of these changes in risk for
regulatory capital under the proposed changes to the Basel Capital Accord. We
find that measured risk increased after the crisis and then fell as the recovery
took hold. In turn, despite the limitations of the data, we find that the
proposed internal ratings-based approach would have generated large swings in
regulatory capital requirements over the second half of the 1990s, with required
capital increasing significantly in the aftermath of the crisis, and then
falling as the economy recovered. Looking forward, if movements in actual bank
capital were to show this same cyclical variation, then business cycle
fluctuations might be amplified by developments in the banking industry.