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Bank ratings: what determines their quality?

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  • Harald Hau
  • Sam Langfield
  • David Marques-Ibanez

Abstract

This paper examines the quality of credit ratings assigned to banks in Europe and the United States by the three largest rating agencies over the past two decades. We interpret credit ratings as relative assessments of creditworthiness, and define a new ordinal metric of rating error based on banks’ expected default frequencies. Our results suggest that rating agencies assign more positive ratings to large banks and to those institutions more likely to provide the rating agency with additional securities rating business (as indicated by private structured credit origination activity). These competitive distortions are economically significant and help perpetuate the existence of ‘too-big-to-fail’ banks. We also show that, overall, differential risk weights recommended by the Basel accords for investment grade banks bear no significant relationship to empirical default probabilities.

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File URL: http://hdl.handle.net/10.1111/10.1111/1468-0327.12009
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Bibliographic Info

Article provided by CEPR & CES & MSH in its journal Economic Policy.

Volume (Year): 28 (2013)
Issue (Month): 74 (04)
Pages: 289-333

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Handle: RePEc:bla:ecpoli:v:28:y:2013:i:74:p:289-333

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References

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  1. Rebel Cole & Lawrence White, 2012. "Déjà Vu All Over Again: The Causes of U.S. Commercial Bank Failures This Time Around," Journal of Financial Services Research, Springer, vol. 42(1), pages 5-29, October.
  2. Marco Pagano & Paolo Volpin, 2010. "Credit ratings failures and policy options," Economic Policy, CEPR & CES & MSH, vol. 25, pages 401-431, 04.
  3. Campello, Murillo & Graham, John R. & Harvey, Campbell R., 2010. "The real effects of financial constraints: Evidence from a financial crisis," Journal of Financial Economics, Elsevier, vol. 97(3), pages 470-487, September.
  4. Becker, Bo & Milbourn, Todd, 2011. "How did increased competition affect credit ratings?," Journal of Financial Economics, Elsevier, vol. 101(3), pages 493-514, September.
  5. Wade Cook & Moshe Kress & Lawrence Seiford, 1986. "Information and preference in partial orders: A bimatrix representation," Psychometrika, Springer, vol. 51(2), pages 197-207, June.
  6. Lawrence J. White, 2010. "Markets: The Credit Rating Agencies," Journal of Economic Perspectives, American Economic Association, vol. 24(2), pages 211-26, Spring.
  7. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "The Aftermath of Financial Crises," NBER Working Papers 14656, National Bureau of Economic Research, Inc.
  8. Jie He & Jun Qian & Philip E. Strahan, 2011. "Credit Ratings and the Evolution of the Mortgage-Backed Securities Market," American Economic Review, American Economic Association, vol. 101(3), pages 131-35, May.
  9. Lily Fang & Ayako Yasuda, 2009. "The Effectiveness of Reputation as a Disciplinary Mechanism in Sell-Side Research," Review of Financial Studies, Society for Financial Studies, vol. 22(9), pages 3735-3777, September.
  10. Garlappi, Lorenzo & Uppal, Raman & Wang, Tan, 2005. "Portfolio Selection with Parameter and Model Uncertainty: A Multi-Prior Approach," CEPR Discussion Papers 5148, C.E.P.R. Discussion Papers.
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  12. Patrick Bolton & Xavier Freixas & Joel Shapiro, 2010. "The Credit Ratings Game," Working Papers 468, Barcelona Graduate School of Economics.
  13. Mathis, Jérôme & McAndrews, James & Rochet, Jean-Charles, 2009. "Rating the raters: Are reputation concerns powerful enough to discipline rating agencies?," Journal of Monetary Economics, Elsevier, vol. 56(5), pages 657-674, July.
  14. Vasiliki Skreta & Laura Veldkamp, 2009. "Ratings Shopping and Asset Complexity: A Theory of Ratings Inflation," NBER Working Papers 14761, National Bureau of Economic Research, Inc.
  15. Donald P. Morgan, 2002. "Rating Banks: Risk and Uncertainty in an Opaque Industry," American Economic Review, American Economic Association, vol. 92(4), pages 874-888, September.
  16. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  17. Sreedhar T. Bharath & Tyler Shumway, 2008. "Forecasting Default with the Merton Distance to Default Model," Review of Financial Studies, Society for Financial Studies, vol. 21(3), pages 1339-1369, May.
  18. Mariathasan, Mike & Merrouche, Ouarda, 2013. "The Manipulation of Basel Risk-Weights," CEPR Discussion Papers 9494, C.E.P.R. Discussion Papers.
  19. Berger, Allen N. & Bouwman, Christa H.S., 2013. "How does capital affect bank performance during financial crises?," Journal of Financial Economics, Elsevier, vol. 109(1), pages 146-176.
  20. Bar-Isaac, Heski & Shapiro, Joel, 2010. "Ratings Quality over the Business Cycle," CEPR Discussion Papers 8156, C.E.P.R. Discussion Papers.
  21. Efraim Benmelech & Jennifer Dlugosz, 2009. "The Credit Rating Crisis," NBER Working Papers 15045, National Bureau of Economic Research, Inc.
    • Efraim Benmelech & Jennifer Dlugosz, 2010. "The Credit Rating Crisis," NBER Chapters, in: NBER Macroeconomics Annual 2009, Volume 24, pages 161-207 National Bureau of Economic Research, Inc.
  22. Jens Hilscher & Mungo Wilson, 2011. "Credit ratings and credit risk," Working Papers 31, Brandeis University, Department of Economics and International Businesss School.
  23. Heski Bar-Isaac & Joel Shapiro, 2011. "Credit Ratings Accuracy and Analyst Incentives," American Economic Review, American Economic Association, vol. 101(3), pages 120-24, May.
  24. Crouhy, Michel & Galai, Dan & Mark, Robert, 2000. "A comparative analysis of current credit risk models," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 59-117, January.
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Citations

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Cited by:
  1. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "The Aftermath of Financial Crises," NBER Working Papers 14656, National Bureau of Economic Research, Inc.
  2. Jeon, Doh-Shin & Lovo, Stefano, 2013. "Credit rating industry: A helicopter tour of stylized facts and recent theories," International Journal of Industrial Organization, Elsevier, vol. 31(5), pages 643-651.
  3. David G. Mayes & Hanno Stremmel, 2014. "The Effectiveness of Capital Adequacy Measures in Predicting Bank Distress," Chapters in SUERF Studies, SUERF - The European Money and Finance Forum.
  4. Oana Toader, 2014. "Quantifying and Explaining Implicit Public Guarantees for European Banks," Working Papers halshs-01015376, HAL.
  5. Mike Mariathasan & Ouarda Merrouche, 2012. "The Manipulation of Basel Risk-Weights. Evidence from 2007-10," Economics Series Working Papers 621, University of Oxford, Department of Economics.
  6. Jeon, Doh-Shin & Lovo, Stefano, 2013. "Credit Rating Industry: a Helicopter Tour of Stylized Facts and Recent Theories," TSE Working Papers 13-376, Toulouse School of Economics (TSE).
  7. Jeon, Doh-Shin & Lovo, Stefano, 2013. "Credit Rating Industry: a Helicopter Tour of Stylized Facts and Recent Theories," IDEI Working Papers 762, Institut d'Économie Industrielle (IDEI), Toulouse.

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