Economic Capital, Loan Pricing and 'Ratings Arbitrage'

28 Pages Posted: 2 Oct 2008

See all articles by Maike Sundmacher

Maike Sundmacher

Trinity Coaching and Consulting

Craig Ellis

Education Centre Australia

Date Written: October 2, 2008

Abstract

The role of economic capital has grown significantly in recent years. Although not a regulatory requirement, an increasing number of financial institutions use economic capital for such purposes as measuring and managing the performance of people, products, risk exposures, and to manage and optimise capital levels. From a risk management perspective, pricing loans based on economic capital is preferred to regulatory capital for its ability to better capture the unique risks and cash flows associated with an exposure. This paper examines the issue of economic capital and its use in loan pricing. Using a loan pricing model based on economic capital we examine the impact of ratings on loan price and show how financial institutions can engage in 'ratings arbitrage' to target higher external credit ratings without having to increase capital levels. The potential implications for regulatory authorities of such arbitrage are also discussed.

Keywords: economic capital, loan pricing, ratings arbitrage

JEL Classification: G210, G280, G320

Suggested Citation

Sundmacher, Maike and Ellis, Craig, Economic Capital, Loan Pricing and 'Ratings Arbitrage' (October 2, 2008). Available at SSRN: https://ssrn.com/abstract=1276927 or http://dx.doi.org/10.2139/ssrn.1276927

Maike Sundmacher (Contact Author)

Trinity Coaching and Consulting ( email )

2315 NE 29th Terrace
Ocala, 34478
United States

Craig Ellis

Education Centre Australia ( email )

Sydney
Australia

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