Basel regulators have received widespread criticism for failing to prevent two credit crises that hit the U.S. over the last two decades. Nonetheless, banks were considerably overcapitalized prior to the onset of the 2007–2009 subprime crisis compared to those which had undergone the 1990–1991 recession. Therefore, if capital requirements were achieved prior to the subprime crisis, how could the Basel framework be blamed again for having accelerated if not caused another credit crunch? We find that the answer to this question lies in the relationship between the capital ratio and the leverage ratio which is governed by risk-weights categories determined by the Basel regulation. We show that changes to risk-weight categories which affect the correlation pattern between both ratios are not reflected in the subprime crisis. This minimizes the implication of the Basel II regulation in the crunch that succeeded its announcement, in contrast to Basel I. We demonstrate that these dynamics are governed by a formula linking the two ratios together which derives from the sensitivity of the risk-based capital ratio to a change in its risk-weight(s). One implication of our work regarding the Basel III regulation consists in validating the newly established capital increments in a mathematical rather than heuristical approach.

In this study, we use a factor model in order to decompose sovereign Credit Default Swaps (CDS) spreads into default, liquidity, systematic liquidity and correlation components. By calibrating the model to sovereign CDSs and bonds we are able to present a better decomposition and a more accurate measure of spread components. Our analysis reveals that sovereign CDS spreads are highly driven by liquidity (55.6% of default risk and 44.32% of liquidity) and that sovereign bond spreads are less subject to liquidity frictions and therefore could represent a better proxy for sovereign default risk (73% of default risk and 26.86% of liquidity). Furthermore, our model enables us to directly study the effect of systematic liquidity and flight-to-liquidity risks on bond and CDS spreads through the factor sensitivity matrix. We find that these risks do have an influence on the default intensity and they contribute significantly to spread movements. Finally, our empirical results advance the idea that the increase in the CDS spreads observed during the crisis period was mainly due to a surge in liquidity rather than to an increase in the default intensity.

We investigate how shocks to the reputation of credit rating agencies and the subsequent introduction of stricter regulation affect investors’ reaction to rating signals. We focus on three major episodes of reputational distress: the Enron/WorldCom scandals, the subprime crisis and the lawsuit against Standard & Poor’s. We document a stronger response of stock investors to downgrades in the aftermath of reputational shocks, which is not, however, accompanied by an improvement in rating quality. Our results are consistent with a scenario where, following evidence of misrating, market investors conclude that ratings are generally overstated and infer greater negative information from downgrades. The effect is stronger for the investment-grade segment, where rating errors have a wider reputational impact. The introduction of new regulatory measures such the SOX Act, the CRA Reform Act and the Dodd-Frank Act, seems instead to improve rating quality and soften investors’ response.