Simplified Standard Approach: An Alternative Model to Mitigate Incentives for Rating Centered Regulatory Arbitrage

39 Pages Posted: 10 May 2011 Last revised: 15 May 2011

See all articles by Rodrigo Gonzalez

Rodrigo Gonzalez

Banco Central do Brasil; Bank of International Settlements

Fernando Sotelino

School of International and Public Affairs, Columbia University

José Savoia

FEA-USP

Date Written: May 1, 2011

Abstract

This paper begins with an assessment of the Dodd-Frank Act and the European Commission financial reform proposal regarding Credit Rating Agencies (CRAs) business models, supervision and regulatory reliance on the use of Credit Rating Agencies’ (CRAs) opinions. It concludes that they still do not eliminate important moral hazard and conflict-of-interest distortions by failing to neutralize the incentives towards rating-centered regulatory arbitrage. A perspective of the three Basel Accords o CRAs’ opinions shows that Basel II created excessive reliance on external ratings, an issue Basel III ignores. Basel I, on the other hand, prevented rating centered regulatory arbitrage, as the option to “optimize” regulatory capital based on ratings (external or internal) was simply not available. Closer examination of how unexpected losses (UL) are calculated brings to the surface the question of whether external credit rating methodologies, originally conceived to estimate probability of default (PD) and loss given default (LGD), can be a reliable basis for determination of Unexpected Losses (UL), the key determinant for minimum capital requirements.

The alternative presented herein is to incorporate the Basel I flat 100% RWA for non-covered credit exposures and to recognize collateral (alone) as a credit mitigator. This proposal is derived from the Brazilian Simplified Standard Approach, since 2007, the law of land in Brazil, in lieu of the Standardized Approach. This approach may imply in higher capital charges than under the current Basel II and proposed Basel III frameworks, but it would eliminate incentives to rating centered regulatory arbitrage, because the bank (buy side) would not be able to benefit from the inflated ratings. In addition, financial institutions would have the regulatory incentives to conduct more careful assessment of underlying assets and engage in contractual arrangements allowing for swift enforcement of collateral obligations; prudential supervision would be made more concrete and effective; and CRAs would be properly incentivized to be again only a source of independent high quality credit opinions.

Keywords: Basel, CRA, ratings, regulations, banking, standard approach (SA), Simplified Standard Approach (SSA), Brazil

JEL Classification: G38

Suggested Citation

Gonzalez, Rodrigo and Sotelino, Fernando and Ferreira Savoia, Jose Roberto, Simplified Standard Approach: An Alternative Model to Mitigate Incentives for Rating Centered Regulatory Arbitrage (May 1, 2011). Available at SSRN: https://ssrn.com/abstract=1836223 or http://dx.doi.org/10.2139/ssrn.1836223

Rodrigo Gonzalez (Contact Author)

Banco Central do Brasil ( email )

P.O. Box 08670
SBS Quadra 3 Bloco B - Edificio-Sede
Brasilia, Distr. Federal 70074-900
Brazil

Bank of International Settlements ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

Fernando Sotelino

School of International and Public Affairs, Columbia University ( email )

420 West 118th Street
New York, NY 10027
United States

Jose Roberto Ferreira Savoia

FEA-USP ( email )

Av. Prof. Luciano Gualberto 908
São Paulo SP, São Paulo 05508-900
Brazil

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