Rating Models Mistakes and Implications for the Basel Committee on Banking Regulation

Abstract

Rating agencies have been key players in various financial crisis not just the current one but also in previous episodes such as the Asian crisis. In this paper we address the following issues: (i) the methodological errors in the agencies rating systems regarding corporate and sovereign debt (ii) Basel Committee banking regulation proposal regarding the agencies’ role in establishing the minimum capital requirements. We have analyzed the relationship between ratings and default frequencies for corporate and sovereign bonds in the pre-crisis period and we have identified inconsistencies in the rating system. Another interesting result is that it is not possible to discriminate between issuers with such a large number of rating scales. We concluded that the actual credit risk regulation gravitate around models based on rating systems that cannot be estimated or validated with the guarantees of rigour and allows regulatory arbitrage by banks.