Financial Stability Paper No. 3
By James Benford and Erlend Nier
The use of credit ratings to set capital requirements under Basel II represents an important change to the way banks are regulated. While encouraging better risk management by banks, it also raises the possibility that capital requirements might vary with economic conditions, creating risks to the stability of the financial system. This paper offers some evidence on the likely magnitude of these effects. It then sets out a framework that will be used by the Bank and FSA to monitor Basel II capital requirements. The Bank is particularly interested in possible implications of cyclical variability in capital requirements under Basel II for the UK banking sector in aggregate, while the FSA’s focus is the capital adequacy of individual banks. The paper finally suggests that the industry as well as market participants, can play a part in avoiding potential unintended consequences of Basel II — through careful capital planning by banks, and scrutiny, by market participants, of the outputs of banks’ rating systems.