No. 548 - The Basel Committee approach to risk - weights and external ratings: what do we learn from bond spreads?

The Basel Committee for Banking Supervision designed a system of risk weights (the so called “standardised approach”) to measure the riskiness of banks’ loan portfolios. Its ability to adequately reflect risk is empirically investigated in this paper, through an analysis of the economic capital allocations implied in corporate bond spreads. This is based on a unique dataset of issuance spreads, ratings and other relevant bond variables (such as maturity, face value, time of issuance and currency of denomination) including 7,232 eurobonds issued mostly by Canadian, European, Japanese and U.S. companies during 1991- 2003. Three main results emerge. First, the spread/rating relationship is strongly significant with spreads increasing when ratings worsen. Second, the estimated spreads per rating class indicate that the risk/rating relationship might be steeper than the one approved by the Basel Committee. Finally the difference between the spread/rating relation of banks and nonfinancial firms appears quite blurred and statistically questionable. Following this empirical evidence, we underline some adjustments in the standardised approach risk-weights that might be considered for the future versions of the Basel Accord.