Basel II and Fostering the Disclosure of Banks' Internal Credit Ratings

Abstract

Advances in risk management capabilities should make it profitable for major banks to rely on internal credit ratings to calculate Basel II capital requirements (IRB approach). Firms and, more generally, market participants would benefit from the disclosure of these ratings. Banks, however, have no incentives to make their rating data publicly available. This paper proposes a regulatory framework to efficiently solve this incentive issue. It first shows that there are benefits in requiring the disclosure of internal ratings. In particular, it would reduce the cost of capital for both large and small borrowers while facilitating investor diversification.

To be sure, internal rating disclosure would also have its costs. For example, market volatility may increase, whereas lender-borrower relationships may suffer. This paper argues that it is possible to design a regulatory framework under which the benefits of mandatory rating disclosure clearly outweigh its costs. Banks opting for the IRB approach would have to provide their internal ratings to one of several regional entities. The latter would consolidate the data collected and give each borrower a rating equal to the average of the ratings it gets from its lenders. The average rating would be disclosed to the public unless the borrower has opted for non-disclosure. Relying upon multiple regional entities may cause some uncertainty (a given firm may get diverging average ratings), but it would also reduce moral hazard effects and foster competition in the rating industry.