Bank 'ratings arbitrage': Is LGD a blind spot in economic capital calculations?

In banking, economic capital is commonly referred to as the level of capital a financial institution needs to hold in order to achieve or maintain its target external credit rating. From a risk management perspective, pricing loan assets 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. 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 by manipulating loss given default data. The potential implications for regulatory authorities of such arbitrage are also discussed.