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Bank ratings: what determines their quality?

  • Hau, Harald
  • Langfield, Sam
  • Marqués-Ibáñez, David

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 contribute to 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. JEL Classification: G21, G23, G28

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Paper provided by European Central Bank in its series Working Paper Series with number 1484.

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Date of creation: Oct 2012
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Handle: RePEc:ecb:ecbwps:20121484
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  1. Patrick Bolton & Xavier Freixas & Joel Shapiro, 2009. "The Credit Ratings Game," NBER Working Papers 14712, National Bureau of Economic Research, Inc.
  2. Mariathasan, Mike & Merrouche, Ouarda, 2013. "The Manipulation of Basel Risk-Weights," CEPR Discussion Papers 9494, C.E.P.R. Discussion Papers.
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  4. Matthias Efing, 2013. "Bank Capital Regulation with an Opportunistic Rating Agency," CESifo Working Paper Series 4267, CESifo Group Munich.
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  6. Marco Pagano & Paolo Volpin, 2009. "Credit Ratings Failures and Policy Options," CSEF Working Papers 239, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
  7. Bar-Isaac, Heski & Shapiro, Joel, 2010. "Ratings Quality over the Business Cycle," CEPR Discussion Papers 8156, C.E.P.R. Discussion Papers.
  8. Luc Laeven & Harry Huizinga, 2009. "Accounting Discretion of Banks During a Financial Crisis," IMF Working Papers 09/207, International Monetary Fund.
  9. Raman Uppal & Lorenzo Garlappi & Tan Wang, 2004. "Portfolio Selection with Parameter and Model Uncertainty: A Multi-Prior Approach," Money Macro and Finance (MMF) Research Group Conference 2004 54, Money Macro and Finance Research Group.
  10. Cole, Rebel A. & White, Lawrence J., 2010. "Déjà vu all over again: The causes of U.S. commercial bank failures this time around," MPRA Paper 24690, University Library of Munich, Germany, revised 28 Jul 2010.
  11. Reinhart, Carmen M. & Rogoff, Kenneth, 2009. "The Aftermath of Financial Crises," CEPR Discussion Papers 7209, C.E.P.R. Discussion Papers.
  12. Bertay, Ata Can & Demirgüç-Kunt, Asli & Huizinga, Harry, 2013. "Do we need big banks? Evidence on performance, strategy and market discipline," Journal of Financial Intermediation, Elsevier, vol. 22(4), pages 532-558.
  13. 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.
  14. 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.
  15. Becker, Bo & Milbourn, Todd, 2011. "How did increased competition affect credit ratings?," Journal of Financial Economics, Elsevier, vol. 101(3), pages 493-514, September.
  16. 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.
  17. 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.
  18. 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.
  19. 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.
  20. 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.
  21. 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.
  22. 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.
  23. Jens Hilscher & Mungo Wilson, 2011. "Credit ratings and credit risk," Working Papers 31, Brandeis University, Department of Economics and International Businesss School.
  24. Frank Packer & Nikola Tarashev, 2011. "Rating methodologies for banks," BIS Quarterly Review, Bank for International Settlements, June.
  25. 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.
  26. 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.
  27. Lawrence J. White, 2010. "Markets: The Credit Rating Agencies," Journal of Economic Perspectives, American Economic Association, vol. 24(2), pages 211-26, Spring.
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