Procyclicality and the New Basel Accord: banks' choice of loan rating system

The Basel Committee on Banking Supervision is proposing to introduce, in 2005, new risk-based requirements for internationally active (and other significant) banks. These will replace the relatively risk-invariant requirements in the current Accord. This article examines the implications of these new risk-based requirements for procyclicality, 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. The paper finds that rating schemes which are designed to be stable over the cycle, akin to those of the external rating agencies, would not increase procyclicality but ratings which are conditioned on the point in the cycle, akin to a Merton approach, could substantially increase procyclicality. This makes the question of which rating schemes banks will use very important. The paper uses a general equilibrium model of the financial system 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. The Committee may need to rule out some types of rating scheme currently used by the banks.