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# **Introduction**

The release for public comments in June 1999 of the new Basel Committee proposal on bank Capital Asset Requirements (CARs) has ignited a lively discussion on whether and how the orientation taken by the Committee should be revised. Part of the criticism questions the role that the proposal assigns to external ratings. Specifically, according to the proposal, CARs on assets vis-a-vis high-rated agents would be much lower than CARs on assets vis-a-vis low-rated and non-rated agents. This would be a desirable step towards enhancing bank efficiency in allocating loans if credit ratings displayed a homogeneous quality across markets and borrowers. Unfortunately, whereas credit rating agencies have a longer record in assessing the health of banks and corporations in the USA and some other developed countries, their experience with sovereign and private sector ratings in NIHICs' is often limited to the last decade, which is likely to affect the quality of ratings.<sup>2</sup> In this paper we provide evidence that linking bank CARs to external ratings would, from the perspective of less developed financial systems, introduce modest improvements at the cost of substantial distortions. Volatility of banks' capital requirements in poorer countries would be increased and the cost of capital for the best institutions of those countries would be higher than for peer institutions from more developed economies. In turn, this would negatively affect the availability and cost of credit in NHICs. The damage would stem from three distinct effects. The first effect is mundane in nature: as ratings are by far less widespread for banks and corporations in NHICs, bank CARs would not decrease (or increase) in these countries according to the risk exposure of individual corporations, as opposed to what would happen for highincome countries (HICs). The second effect stems from the fact that, based on the historical experience, NHICs have experienced downgradings of their sovereign ratings which a number of recent studies have labeled as "excessive". 3 Since the sovereign rating is generally the pivot of all the other country's ratings -determining _defacto_ a ceiling for the private sector- this entails a generalized negative impact on the country's bank CARs. The third effect depends on the fact that bank and corporate ratings in NHICs are more tightly linked to sovereign rating changes, introducing an element of asymmetry between the treatment of bank CARs in HICs and NHICs.

From these perspective, our findings suggest a reassessment of the role assigned to external ratings in the new Basel Committee proposal, with a view to minimizing the detrimental impact that the regulatory use of external ratings could have for NHICs. A modest reassessment could be to grant banks a time frame to phase-in the new rules long enough to allow for a substantial increase in the number of rated banks and corporations

**1** Non-high-income countries include high middle-income, middle-income, and low-income countries as categorized by the World Bank.

**_2_** IMF (1999) provides an extensive discussion of a) the problems faced in assessing the accuracy of ratings in developing economies; b) the changes in the analytical methodology used by credit rating agencies during the recent crises.

3See among others, Ferri, Liu and Stiglitz (1999) and Monfort and Mulder (2000). See Cantor and Packer (1994, 1996) for early analyses of rating agencies' behavior. See also Kuhner (1999) and Partnoy (1999) for additional critical discussion of rating agencies' assessments.

_Ferri, Liu, and Majnoni, "The Role of Rating Agency Assessments in Less Developed Countries. Impact of the Proposed Basel Guidelines"_