Manipulating an IRB model: considerations about the Basel II framework

Purpose – The purpose of this paper is to contribute to the debate on the current economic crisis and to highlight the importance of the counter‐party credit risk, which was surprisingly neglected by the Basel Committee on Banking Supervision in its proposed enhancements to the Basel II framework. The paper supports the proposition that there is an incentive for synergy between bank management, corporate management and auditors as long as all these parties' remuneration schemes are based on the same principles. Design/methodology/approach – In this paper an advanced IRB corporate credit‐rating system is constructed in accordance with the Basel II framework and the current literature. The impact of common creative accounting and banking practices on the manipulation of that system is explored. Findings – The paper shows how creative accounting and banking practices can be used in manipulating an advanced IRB corporate credit‐rating system, and thus presenting a high‐risk corporation as a highly attractive (low‐risk) bank customer. Practical implications – The regulatory authorities should take into consideration the inability of rating agencies to ascertain the risk associated with the US sub‐prime mortgage market and the decline of auditors' independence. Originality/value – The contribution of the paper is the propositions made to the Basel Committee on Banking Supervision in order to enhance the Basel II framework, and avoid repetition of the current economic crisis in the future.