An Analysis and Critique of the BIS Proposal on Capital Adequacy and Ratings

Abstract

In June 1999, the BIS released its long awaited proposal on reform of the 8% risk-based capital ratio for credit risk that has been in effect since 1993 (see Basel Committee on Banking Supervision, 1999).¹ The 8% ratio has been criticized on at least three major grounds. First, it gives an equal risk-weighting to all corporate credits whether of high or low credit quality. Second, it fails to incorporate potential capital savings from credit (loan) portfolio diversification. The latter is a result of its simple additive nature. And third, it has led to extensive regulatory capital arbitrage which adds to the riskiness of bank asset portfolios.

This paper’s drafts have been prepared for two symposia on the proposed new guidelines; the first held at the University of Frankfurt on 2 December 1999 and the second at the NYU Salomon Center’s Stern School of Business forum, held on 25 February 2000.

The authors are respectively the Max L. Heine and John M. Schiff Professors of Finance, Stern School of Business, NYU. They wish to thank several individuals from Standard and Poor’s and Moody’s for their data assistance. The computational assistance of Vellore Kishore and Sreedhar Bharath are also acknowledged as well as the coordination by Robyn Vanterpool. The opinions presented are solely of the authors.