This paper investigates the effects of credit ratings-contingent financial regulation on foreign bank lending behaviour and examines the sensitivity of international bank flows to debtor countries’ sovereign credit rating changes before and after the implementation of the Basel 2 risk-based capital regulatory rules.

The research finds evidence that sovereign credit re-ratings that lead to changes in risk-weights for capital adequacy requirements have become more significant since the implementation of Basel 2 rules for assessing banks’ credit risk under the standardised approach. This evidence is consistent with global banks acting via their international lending decisions to minimise required capital charges associated with the use of ratings-contingent regulation. There is evidence that banking regulation induced foreign lending has also heightened the perceived sovereign risk levels of recipient countries, especially those with investment grade status.