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August 2011

Analyzing Bank Ratings: Key Determinants and Procyclicality

A paper by Elisabeth Van Laere (National University of Singapore) and Bart Baesens (Katholieke Universiteit Leuven)

In a recent working paper, RMI research fellow, Dr. Elisabeth Van Laere, and her co-author, provide a comprehensive analysis on the credit ratings of banks by Moody's and Standard & Poor's (S&P). 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 financial crisis, for many observers of financial markets, credit ratings continue to play an essential role.

Evaluating credit risk is not that trivial. This seems to be especially true for financial intermediaries. Existence of a significant number of split ratings Moody's and S&P have over financial intermediaries suggests that banks are more difficult to rate because of their opaqueness. This additional lack of transparency is linked to the banks' asset base and their high leverage, which create agency problems and further increase uncertainty over their assets. 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. Using a multilevel logistic regression, the authors test this assumption by identifying some important differences between Moody's and S&P's bank ratings.

The paper presents a joint examination of how different factors influence the assignment of long term bank ratings by Moody's and S&P using a unique 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 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.

Finally, the authors check their findings on a sample of banks that are rated by both rating agencies while controlling for potential sample selection bias. They find only limited evidence of mimicking behaviour between Moody's and S&P.

The paper's 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. Dr. Van Laere and Dr. Baesens provide clear evidence that this is not necessarily the case. Moody's and S&P seem to have different rating determinants and different sensitivity towards the business cycle.

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Published quarterly by Risk Management Institute, NUS
Editor: Ivy Wang (rmiwy@nus.edu.sg)