Using Loan Rates to Measure and Regulate Bank Risk: Findings Immodest Proposal

Abstract

There is strong evidence that the interest rates charged by banks on the flow of newly extended Commercial & Industrial (C&I) loans predict future loan performance and CAMEL rating downgrades by bank supervisors. While internal risk ratings have little explanatory power for future loan performance, they do help predict future CAMEL downgrades. These findings suggest that supervisors might consider using interest rates in the off-site surveillance of banks. At the same time, we propose that reformers consider basing capital requirements and deposit insurance premia on loan interest rates instead of (or in addition to) internal risk ratings and models.

Keywords: Deposit insurance reform, credit risk pricing, risk-based capital regulation