An analysis and critique of the BIS proposal on capital adequacy and ratings

This paper examines two specific aspects of stage 1 of the Bank for Interna tional Settlement's (BIS's) proposed reforms to the 8% risk-based capital r atio. We argue that relying on "traditional" agency ratings could produce c yclically lagging rather leading capital requirements, resulting ill an enh anced rather than reduced degree of instability in the banking and financia l system. Despite this possible shortcoming, we believe that sensible risk based weighting of capital requirements is a step in the right direction. T he current risk based bucketing proposal, which is tied to external agency ratings, or possibly to internal bank ratings, however, lacks a sufficient degree of granularity. In particular, lumping A and BBB (investment grade c orporate borrowers) together with BE and B (below investment grade borrower s) severely misprices risk within that bucket and calls, at a minimum, for that bucket to be split into two. We examine the default loss experience on corporate bonds for the period 1981-1999 and propose a revised weighting s ystem which more closely resembles the actual loss experience on credit ass ets. (C) 2001 Elsevier Science B.V. All rights reserved.