The Basle Accord of 1988 regulates how much equity banks must set aside as a cushion against the default risk. In its 1999 proposal for a new Accord, the Basle Committee seeks to introduce different equity ratios for customers of different risk levels. The proposal strongly favors external ratings as a means of risk determination. German banks, on the other hand, demand acknowledgement of their internal ratings. This paper shows that, even if assumed that banks have better diagnosis skill than external rating agencies, external ratings are better able to implement the goals of the Basle Committee than internal ratings. This is due to a lack of incentives to truthfully reveal their diagnosis results. These incentives may be provided by supervision of internal ratings, even if imperfect and only occasional. However, this requires that a fine be imposed if the supervising authority comes to a result different from the internal rating assigned by the bank.
diagnosis theory imperfect decision making credit worthiness tests