Publication: Perverse Effects of a Ratings-Related Capital Adequacy System
Loading...
Date
2000-06
ISSN
Published
2000-06
Author(s)
Editor(s)
Abstract
It has recently been proposed that banks be allowed to hold less capital against loans to borrowers who have received a favorable rating by an approved rating agency. But a plausible model of rating-agency behavior shows that this strategy could have perverse results, actually increasing the risk of deposit insurance outlays. First, there is an issue of signaling, with low-ability borrowers possibly altering their behavior to secure a lower capital requirement for their borrowing. Second, establishing a regulatory cut-off may actually reduce the amount of risk information made available by raters. Besides, the credibility of rating agencies may not be damaged by neglect of the risk of unusual systemic shocks, although deposit insurers greatest outlays come chiefly at times of systemic crisis. And using agencies' individual ratings is unlikely to be an effective early-warning system for the risk of systemic failure, so use of the ratings could lull policymakers into a false sense of security. It is important to harness market information to improve bank safety (for example, by increasing the role of large, well-informed, but uninsured claimants), but this particular approach could be counterproductive. Relying on ratings could induce borrowers to increase their exposure to systemic risk even if they reduce exposure to specific risk.
Link to Data Set
Citation
“Honohan, Patrick. 2000. Perverse Effects of a Ratings-Related Capital Adequacy System. Policy Research Working Paper;No. 2364. © http://hdl.handle.net/10986/19828 License: CC BY 3.0 IGO.”
Associated URLs
Associated content
Other publications in this report series
Publication The Macroeconomic Implications of Climate Change Impacts and Adaptation Options(Washington, DC: World Bank, 2025-05-29)Estimating the macroeconomic implications of climate change impacts and adaptation options is a topic of intense research. This paper presents a framework in the World Bank's macrostructural model to assess climate-related damages. This approach has been used in many Country Climate and Development Reports, a World Bank diagnostic that identifies priorities to ensure continued development in spite of climate change and climate policy objectives. The methodology captures a set of impact channels through which climate change affects the economy by (1) connecting a set of biophysical models to the macroeconomic model and (2) exploring a set of development and climate scenarios. The paper summarizes the results for five countries, highlighting the sources and magnitudes of their vulnerability --- with estimated gross domestic product losses in 2050 exceeding 10 percent of gross domestic product in some countries and scenarios, although only a small set of impact channels is included. The paper also presents estimates of the macroeconomic gains from sector-level adaptation interventions, considering their upfront costs and avoided climate impacts and finding significant net gross domestic product gains from adaptation opportunities identified in the Country Climate and Development Reports. Finally, the paper discusses the limits of current modeling approaches, and their complementarity with empirical approaches based on historical data series. The integrated modeling approach proposed in this paper can inform policymakers as they make proactive decisions on climate change adaptation and resilience.Publication Global Poverty Revisited Using 2021 PPPs and New Data on Consumption(Washington, DC: World Bank, 2025-06-05)Recent improvements in survey methodologies have increased measured consumption in many low- and lower-middle-income countries that now collect a more comprehensive measure of household consumption. Faced with such methodological changes, countries have frequently revised upward their national poverty lines to make them appropriate for the new measures of consumption. This in turn affects the World Bank’s global poverty lines when they are periodically revised. The international poverty line, which is based on the typical poverty line in low-income countries, increases by around 40 percent to $3.00 when the more recent national poverty lines as well as the 2021 purchasing power parities are incorporated. The net impact of the changes in international prices, the poverty line, and new survey data (including new data for India) is an increase in global extreme poverty by some 125 million people in 2022, and a significant shift of poverty away from South Asia and toward Sub-Saharan Africa. The changes at higher poverty lines, which are more relevant to middle-income countries, are mixed.Publication Geopolitical Fragmentation and Friendshoring(Washington, DC: World Bank, 2025-06-26)This paper examines the relationship between geopolitical fragmentation and friendshoring of foreign investments over time, countries, and sectors. The analysis uses comprehensive data on foreign direct investments covering greenfield projects, mergers and acquisitions, and stocks of affiliates, as well as data on four alternative measures of geopolitical distance between countries. The gravity estimations suggest that, first, geopolitical differences have a negative effect on foreign investments and the magnitude has heightened in the post-pandemic period compared to a decade ago. Second, it is primarily the companies from advanced Western economies whose foreign investment decisions are increasingly shaped by friendshoring forces. Finally, the paper shows that friendshoring is not only confined to strategic industries, implying that allocations of foreign direct investments may not solely reflect national security or resilience considerations.Publication Soaring Food Prices Threaten Recent Economic Gains in the EU(Washington, DC: World Bank, 2025-07-02)The surge in food prices following the 2021 economic rebound has become a significant concern for households, particularly low-income ones, in Bulgaria, Croatia, Poland, and Romania. Food price inflation, which surpasses general inflation rates, risks worsening poverty and food insecurity in these countries. This paper explores the distributional impacts of rising food prices and the effectiveness of government response measures. Low-income households, who allocate a larger share of their income to food, are disproportionately affected and are struggling to cope with unexpected expenses, leading to increased difficulties in accessing proper nutrition. Simulations indicate that rising food prices contribute to higher poverty rates and greater income inequality, especially among vulnerable populations. They also suggest that the main poverty-targeted social assistance schemes offer critical support for the extreme poor, but expanding both coverage and benefits is vital to shield all at-risk individuals. Targeted policies that balance immediate relief with long-term resilience-building are essential to addressing the challenges posed by escalating food prices.Publication Disentangling the Key Economic Channels through Which Infrastructure Affects Jobs(Washington, DC: World Bank, 2025-04-03)This paper takes stock of the literature on infrastructure and jobs published since the early 2000s, using a conceptual framework to identify the key channels through which different types of infrastructure impact jobs. Where relevant, it highlights the different approaches and findings in the cases of energy, digital, and transport infrastructure. Overall, the literature review provides strong evidence of infrastructure’s positive impact on employment, particularly for women. In the case of electricity, this impact arises from freeing time that would otherwise be spent on household tasks. Similarly, digital infrastructure, particularly mobile phone coverage, has demonstrated positive labor market effects, often driven by private sector investments rather than large public expenditures, which are typically required for other large-scale infrastructure projects. The evidence on structural transformation is also positive, with some notable exceptions, such as studies that find no significant impact on structural transformation in rural India in the cases of electricity and roads. Even with better market connections, remote areas may continue to lack economic opportunities, due to the absence of agglomeration economies and complementary inputs such as human capital. Accordingly, reducing transport costs alone may not be sufficient to drive economic transformation in rural areas. The spatial dimension of transformation is particularly relevant for transport, both internationally—by enhancing trade integration—and within countries, where economic development tends to drive firms and jobs toward urban centers, benefitting from economies scale and network effects. Turning to organizational transformation, evidence on skill bias in developing countries is more mixed than in developed countries and may vary considerably by context. Further research, especially on the possible reasons explaining the differences between developed and developing economies, is needed.
Journal
Journal Volume
Journal Issue
Collections
Related items
Showing items related by metadata.
Publication Can The Unsophisticated Market Provide Discipline?(World Bank, Washington, D.C., 2004-08)The authors question the widespread belief that market discipline on banks cannot be effective in less developed financial environments. There is no systematic tendency for low-income countries to lack the prerequisites for market discipline. Offsetting factors to the weaker market and formal information infrastructures are (1) the less complex character of banking business in low-income countries; (2) the growing internationalization of these markets through the presence of foreign banks, and through international trading of the debt and equity of locally-controlled non-government banks; and (3) the smaller size of the business and financial community. However, continuing dominance by public sector banks in some countries limits the likely development of market monitoring, which is clearly a cause for concern, given the disappointing record of governments around the world as monitors of their self-owned banks. Countries should build on this potential for market discipline by limiting the role of explicit deposit guarantees, reducing state ownership of banks where it is prevalent, and not putting all their eggs in the supervisory basket. Greater disclosure, for example, of how risk taking is rewarded and how rating agencies earn their fees would support the development of better market monitoring. Enhancing market discipline (pillar three) is much more likely to be of use in most developing countries than addressing the refinements of the risk-weighting system of Basel II's first pillar.Publication Financial Transactions Tax : Panacea, Threat, or Damp Squib?(2010-03-01)Attempts to raise a significant percentage of gross domestic product in revenue from a broad-based financial transactions tax are likely to fail both by raising much less revenue than expected and by generating far-reaching changes in economic behavior. Although the side-effects would include a sizable restructuring of financial sector activity, this would not occur in ways corrective of the particular forms of financial overtrading that were most conspicuous in contributing to the crisis.Publication Bank Capital and Systemic Stability(World Bank, Washington, DC, 2014-06)This paper distinguishes among various types of capital and examines their effect on system-wide fragility. The analysis finds that higher quality forms of capital reduce the systemic risk contribution of banks, whereas lower quality forms can have a destabilizing impact, particularly during crisis periods. The impact of capital on systemic risk is less pronounced for smaller banks, for banks located in countries with more generous safety nets, and in countries with institutions that allow for better public and private monitoring of financial institutions. The results show that regulatory capital is effective in reducing systemic risk and that regulatory risk weights are correlated with higher future asset volatility, but this relationship is significantly weaker for larger banks. The paper also finds that increased regulatory risk-weights not correlated with future asset volatility increase systemic fragility. Overall, the results are consistent with the theoretical literature that emphasizes capital as a potential buffer in absorbing liquidity, information, and economic shocks reducing contagious defaults.Publication Instruments to Tap Capital Markets for Funding in Housing and Related Considerations Concerning the Sistema Brasileiro de Poupança e Empréstimo(Washington, DC, 2011-06-08)At the request of the Secretariat of Economic Policy (SPE) at the Brazilian Ministry of Finance (Fazenda), the World Bank carried out a second phase of the Non-Lending Technical Assistance (NLTA) aimed at supporting the Government's ongoing housing sector reform efforts. Work provided under Phase II of the NLTA focused on two interrelated issues : Proposing the introduction of new instruments which will allow lenders to raise long-term funds from the capital markets; and Identifying options to ensure a better alignment of the Sistema Financeiro de Habitação (SFH), with its two pillars SBPE and FGTS, with the introduction of new capital market instruments.Publication Cyclical Effects of Bank Capital Requirements with Imperfect Credit Markets(2009-09-01)This paper analyzes the cyclical effects of bank capital requirements in a simple model with credit market imperfections. Lending rates are set as a premium over the cost of borrowing from the central bank, with the premium itself depending on firms effective collateral. Basel I- and Basel II-type regulatory regimes are defined and a capital channel is introduced through a signaling effect of capital buffers on the cost of bank deposits. The macroeconomic effects of various shocks (a drop in output, an increase in the refinance rate, and a rise in the capital adequacy ratio) are analyzed, under both binding and nonbinding capital requirements. Factors affecting the procyclicality of each regime (defined in terms of the behavior of the risk premium) are also identified and policy implications are discussed.
Users also downloaded
Showing related downloaded files
Publication Financing Firm Growth(Washington, DC: World Bank, 2025-03-13)Well-functioning capital markets can foster economic growth and allocate resources efficiently. Firms can tap into a broader funding base by issuing debt and equity in capital markets, often at cheaper rates and longer tenors than through other sources of external finance, such as banks. However, capital markets in low- and middle-income countries have lagged those in high-income countries. Accordingly, the firms in those countries have more often relied on bank financing or retained earnings to fund investment and expansion, and they have experienced greater financial constraints than their counterparts in high-income countries. Financing Firm Growth: The Role of Capital Markets in Low- and Middle-Income Countries shows that the gap in capital market financing between low- and middle-income countries and high-income countries has narrowed, with resulting benefits for both the firms accessing those markets and for the countries in which they operate. The analysis reveals greater participation by firms from low- and middle-income countries in capital markets since the 2000s. Most of these firms are new participants in capital markets, and they tend to be smaller, younger, and more productive than those already participating. Firms are deploying capital raised in markets to become more productive—investing in physical assets, hiring more workers, and expanding operations, spurring growth both at the firm level and within their economies. To reach these findings, the analysis used a novel database of the universe of bond and equity issuances from companies between 1990 and 2022. The insights leverage data from nearly 80,000 firms worldwide, focusing on how 20,000 firms across 106 low- and middle-income countries access and use capital market financing. --- “Financing Firm Growth is a groundbreaking exploration that delves into the vital role that capital markets play in driving business expansion in low- and middle-income countries. Backed by data from 80,000 firms across 147 economies, the authors explore the factors underlying capital market growth and its benefits for economies and firms at all levels of development. This book is a must-read for investors, policy makers, and economists shaping the future of global finance.” — Laura Alfaro, Warren Alpert Professor of Business Administration, Harvard Business SchoolPublication Classroom Assessment to Support Foundational Literacy(Washington, DC: World Bank, 2025-03-21)This document focuses primarily on how classroom assessment activities can measure students’ literacy skills as they progress along a learning trajectory towards reading fluently and with comprehension by the end of primary school grades. The document addresses considerations regarding the design and implementation of early grade reading classroom assessment, provides examples of assessment activities from a variety of countries and contexts, and discusses the importance of incorporating classroom assessment practices into teacher training and professional development opportunities for teachers. The structure of the document is as follows. The first section presents definitions and addresses basic questions on classroom assessment. Section 2 covers the intersection between assessment and early grade reading by discussing how learning assessment can measure early grade reading skills following the reading learning trajectory. Section 3 compares some of the most common early grade literacy assessment tools with respect to the early grade reading skills and developmental phases. Section 4 of the document addresses teacher training considerations in developing, scoring, and using early grade reading assessment. Additional issues in assessing reading skills in the classroom and using assessment results to improve teaching and learning are reviewed in section 5. Throughout the document, country cases are presented to demonstrate how assessment activities can be implemented in the classroom in different contexts.Publication Guide to the Debt Management Performance Assessment Tool(Washington, DC, 2008-02-05)The purpose of this document is to provide guidance and supplemental information to assist with country assessments of debt management performance, using the Debt Management Performance Assessment (DeMPA) tool. The DeMPA is a methodology used for assessing public debt management performance through a comprehensive set of 15 performance indicators spanning the full range of government Debt Management (DeM) functions. It is based on the principles set out in the International Monetary Fund (IMF) and World Bank guidelines for public debt management, initially published in 2001 and updated in 2003. It is modeled after the Public Expenditure and Financial Accountability (PEFA) framework for performance measurement of public financial management. The DeMPA has been designed to be a user-friendly tool to undertake an assessment of the strengths and weaknesses in government DeM practices. This guide provides additional background and supporting information so that a no specialist in the area of debt management may undertake a country assessment effectively. The guide can be used by assessors in preparing for and undertaking an assessment. It is particularly useful for understanding the rationale for the inclusion of the indicators, the scoring methodology, and the list of supporting documents or evidence required, and the questions that could be asked for the assessment.Publication World Development Report 2006(Washington, DC, 2005)This year’s Word Development Report (WDR), the twenty-eighth, looks at the role of equity in the development process. It defines equity in terms of two basic principles. The first is equal opportunities: that a person’s chances in life should be determined by his or her talents and efforts, rather than by pre-determined circumstances such as race, gender, social or family background. The second principle is the avoidance of extreme deprivation in outcomes, particularly in health, education and consumption levels. This principle thus includes the objective of poverty reduction. The report’s main message is that, in the long run, the pursuit of equity and the pursuit of economic prosperity are complementary. In addition to detailed chapters exploring these and related issues, the Report contains selected data from the World Development Indicators 2005‹an appendix of economic and social data for over 200 countries. This Report offers practical insights for policymakers, executives, scholars, and all those with an interest in economic development.Publication Mexico Poverty and Equity Assessment(Washington, DC: World Bank, 2025-02-20)This Mexico Poverty and Equity Assessment reviews the evidence about poverty and equity in Mexico over the last two decades, compares it to comparable international experience, and identifies a set of critical areas of policy intervention to answer the opening question. The report aims at contributing to an open conversation in Mexico about how to achieve this essential policy objective. This report postulates three main policy areas needed for poverty eradication in Mexico: inclusive growth, efficient social policy, and infrastructure to confront vulnerability. The report includes four sections, the first three of which collect evidence about poverty, social deprivations, and vulnerability and how the evolution of these three correlates to patterns of economic growth, social protection policy and territorial development. The fourth section provides some quantitative benchmarks of what it would take to eradicate extreme poverty in Mexico. Poverty in Mexico is defined not only in monetary terms, but also in a multidimensional manner that includes social deprivations. These are social deprivations that often define formal-vs-informal employment, so policy changes that close these carencias, as they are called in Mexico, will also reduce the informality gap. This report documents the evolution of poverty, social deprivations, and vulnerability to poverty. It explains the main forces that have driven this evolution and advises that many of these forces may not operate the same in the future as they did in the past. It provides the basis to argue that short to medium term extreme poverty eradication requires newer policy actions in terms of inclusive growth, more efficient social policy, and investments in physical and social infrastructure to reduce vulnerability. The report indicates that short to medium term eradication to extreme poverty is a major, but within reach, development challenge for Mexico.