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Rating Banks in Emerging Markets: What Credit Rating Agencies Should Learn from Financial Indicators

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  • Liliana Rojas-Suarez

    (Institute for International Economics)

Abstract

The rating agencies' and bank supervisors' records of prompt identification of banking problems in emerging markets has not been satisfactory. This paper suggests that such deficiencies could be explained by the use of financial indicators that, while appropriate for industrial countries, do not work in emerging markets. Among the conclusions, this paper shows that the most commonly used indicator of banking problems in industrial countries, the capital-to-asset ratio, has performed poorly as an indicator of banking problems in Latin America and East Asia. This is because of (a) severe deficiencies in the accounting and regulatory framework and (b) lack of liquid markets for bank shares, subordinated debt and other bank liabilities and assets needed to validate the "real" worth of a bank as opposed to its accounting value. In spite of these problems, an appropriate set of indicators for banking problems in emerging markets can be constructed. But such a system should be based not on the quality of banks loans or on levels of capitalization, but on the general principle that good indicators of banking problems are those that reveal the "true" riskiness of individual banks because they are based on markets that work rather than just relying on accounting figures. Of the alternative indicators proposed in this paper, interest rate paid on deposits and interest rate spreads have proven to be strong performers. In contrast to the interpretation of banks' spreads in industrial countries, low spreads in emerging markets have not always indicated an increased in bank efficiency. Instead, low spreads have often reflected the high-risk taking behavior of weak banks. A difficulty that rating agencies may encounter in considering the suggested approach in this paper is that the methodology implies that the appropriate indicators of banks' performance evolve over time as markets develop and that, given large differences among emerging markets, a single set of indicators will not "fit all". The basic principle that "indicators work where markets work" is the leading guide to the selection of effective indicators. In spite of these considerations, we believe that in facing the trade-off between "uniformity across countries" and "effective indicators", rating agencies would be better off by focusing on the latter.

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Paper provided by Peterson Institute for International Economics in its series Working Paper Series with number WP01-6.

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Date of creation: May 2001
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Handle: RePEc:iie:wpaper:wp01-6

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  1. Carmen M. Reinhart & Graciela L. Kaminsky, 1999. "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems," American Economic Review, American Economic Association, vol. 89(3), pages 473-500, June.
  2. Sinkey, Joseph F, Jr, 1975. "A Multivariate Statistical Analysis of the Characteristics of Problem Banks," Journal of Finance, American Finance Association, vol. 30(1), pages 21-36, March.
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  6. Patrick Honohan, 1997. "Banking system failures in developing and transition countries: Diagnosis and predictions," BIS Working Papers 39, Bank for International Settlements.
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  8. Reinhart, Carmen & Goldstein, Morris & Kaminsky, Graciela, 2000. "Assessing financial vulnerability, an early warning system for emerging markets: Introduction," MPRA Paper 13629, University Library of Munich, Germany.
  9. Honohan, Patrick & Klingebiel, Daniela, 2000. "Controlling the fiscal costs of banking crises," Policy Research Working Paper Series 2441, The World Bank.
  10. Gary Whalen & James B. Thomson, 1988. "Using financial data to identify changes in bank condition," Economic Review, Federal Reserve Bank of Cleveland, issue Q II, pages 17-26.
  11. Patrick Honohan & Daniela Klingebiel, 2000. "Controlling fiscal costs of banking crises," Proceedings 682, Federal Reserve Bank of Chicago.
  12. Robert Billings & Brenda González-Hermosillo & Ceyla Pazarbasioglu, 1996. "Banking System Fragility," IMF Working Papers 96/142, International Monetary Fund.
  13. Bongini, Paola & Claessens, Stijn & Ferri, Giovanni, 2000. "The political economy of distress in East Asian financial institutions," Policy Research Working Paper Series 2265, The World Bank.
  14. James R. Barth & R. Dan Brumbaugh & Daniel Sauerhaft & George H.K. Wang, 1985. "Thrift institution failures: causes and policy issues," Proceedings 68, Federal Reserve Bank of Chicago.
  15. Asli Demirgüç-Kunt, 1989. "Deposit-institution failures: a review of empirical literature," Economic Review, Federal Reserve Bank of Cleveland, issue Q IV, pages 2-18.
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