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
Date Written: May 1, 2011
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: Suggested Citation