Bank ratings: key determinants and cyclicality

Over the past decade, the economic environment has been characterised by high-profile business scandals and failures, in which different company stakeholders were involved. In July 2007, the world entered the most profound and disruptive crisis since 1929. Initially originating in the US, it has evolved into a deep and complex crisis at global level, resulting in significant economic damage. Lack of market transparency, the abrupt downgrading of credit ratings and the failure of Lehman Brothers have initiated a global breakdown of trust. In autumn 2008 interbank markets shot down, creating a liquidity crisis that is still having a profound impact on the cost and availability of credit, financial markets and the macro-economy as a whole. Both government and Central Banks have taken numerous measures to address the systemic risk and to refuel the economy. However, it has become clear that the regulatory framework and measures in place were insufficient to tackle the crisis. As such, regulatory and supervisory financial authorities are currently confronted with major challenges.

While upgrading financial regulations and supervision in order to prevent future crises, many authorities are being confronted with the fact that risks taken in the process of financial intermediation are difficult to observe and assess from outside the bank. In the absence of tight regulations, this opaqueness exposes banks to runs and systemic risk. In order to reduce this lack of transparency, credit rating agencies (CRAs)provide information that can help various stakeholders to evaluate the credit risk of issues and issuers. Even though CRAs have been criticized a lot in the latest crisis, for many observers of financial markets, credit ratings continue to play an essential role. They hold a key position in today’s financial markets, where high-quality, widely recognised ratings are a basic condition for a financial market to function properly. Rating reports often provoke comments from regulators, politicians and the business community. A rating change influences stock and bond prices and can have wider ramifications.

Evaluating credit risk is not that trivial. This seems to be especially true for financial intermediaries. The number of split ratings different rating agencies have over financial intermediaries suggests that banks are more difficult to rate because of their opaqueness. However, despite the fact that some agencies systematically assign higher ratings than others, various bank stakeholders tend to implicitly assume that different CRAs have equivalent rating scales and methodologies.

In a recent working paper, Dr Elisabeth Van Laere and Prof Bart Baesens provide a comprehensive analysis on the credit ratings of banks by Moody’s and Standard & Poor’s (S&P). More specifically, the research team has investigated how different factors influence the assignment of S&P and Moody’s long term bank ratings using aunique data set covering different regions, bank sizes, and bank types. By including new bank and country specific variables, the authors clearly show that Moody’s and S&P’s bank ratings are based on different input parameters.

Furthermore, the paper investigates the cyclicality of bank ratings. Credit rating agencies claim that ratings are the outcome of a through-the-cycle methodology which makes them stable and insensitive to temporary credit risk fluctuations. However, even though one of the main goals of CRAs is to provide ratings that are insensitive to cyclical evolution, there is evidence that in reality this is not the case. More specifically the authors show that when due account is taken of systemic time variations in financial variables, evidence of excessive cyclicality disapears for S&P, but is still present for Moody's. This finding suggests that bank ratings of both agencies exhibit a different sensitivity to the business cycle. Furthermore previous findings of a secular tightening of corporate rating standards do not seem to hold for banks. Both for Moody’s and S&P, the authors show that after the inclusion of more complete measures of systematic changes to risk, no significant trend behaviour exists.

This research’ findings are highly relevant for various bank stakeholders, who often tend to assume that Moody’s and S&P have equivalent rating scales and rating processes. This paper shows clear evidence that this is not necessarily the case. Moody’s and S&P seem to have different rating determinants, different sensitivity towards the business cycle and behave differently when rating banks that are rated by both of them.

This article is based on a doctoral dissertation

Van Laere, E. 2010. Capital regulation of financial institutions, the role of ratings and the tension field between regulation and economic reality.

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