Economic capital, loan pricing and 'ratings arbitrage'

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.