Ratings, Rating Agencies and the Global Financial System

In this introductory chapter, we begin with a brief overview of the issues that have motivated our research into the role of credit ratings and credit rating agencies in the global financial system. We then summarize the main themes in each of the papers and highlight the major findings. In the final section, we suggest several policy implications and conclusions that can be drawn from this research.

In capital market history, credit rating agencies were relatively late to appear, being less than a century old. John Moody founded the first rating agency in 1909, in the United States, which in comparison with other countries had a large private bond market and an investing class clamoring for better information. Extensive research by W.B. Hickman and others established that credit rating agencies were able to provide investors with good information on bond quality and the probability of default, but that the agencies’ record was not appreciably different from implicit ratings of public regulatory authorities and the bond market’s own ratings indicated by interest rate spreads. The paper concludes with a discussion of various rationales that have been given for the success of credit rating agencies as businesses in the United States and, increasingly, the world.

When the business of bond credit ratings by independent rating agencies began in the United States early in the twentieth century, bond markets—and capital markets generally—had already existed for at least three centuries. Moreover, for at least two centuries, these old capital markets were to an extent even ‘global.’ That in itself indicates that agency credit ratings are hardly an integral part of capital market history. It also raises several questions. W h y did credit rating agencies first appear when (1909) and where (the United States) they did in history? What has been the experience of capital market participants with agency credit ratings since they did appear? And what roles do agency ratings n ow play in those markets, which in recent decades have again become global, to an even greater extent than previously in history.

This essay explores the historical origins of agency bond ratings and the experience the capital markets have had with them in the twentieth century. T h e latter is pretty much a U.S. story until the 1970s, when the modem globalization of capital markets initiated a rerun of the U.S. story on a worldwide scale. Issues to be addressed include, in part 1, how and why the capital markets were able to function without agency bond ratings for so much their history, and why the agency rating business arose when it did. Part 2 examines the U.S. experience with agency ratings from their inception early in the century to the 1970s, with reference to the markets for both corporate and state and local governmental debt. Part 3 discusses the globalization of the agency bond rating business that has accompanied the globalization of capital markets since the 1970s, with some discussion of various rationales or explanations of the continuing importance of agency ratings in U.S. and global capital markets.

The June 1999 and January 2001 proposals by the Bank for International Settlements (BIS) Basel Committee on Banking Supervision to include borrowers’ credit ratings in assessments of the adequacy of banks’ capital have heightened general interest in the credit rating industry: Who the industry’s firms are; what they do; how they do it; and what the consequences of their actions are. This paper uses the structure-behavior-performance paradigm of “industrial organization” to shed light on the credit rating industry and to provide a framework for arranging initial observations and developing questions for further analysis.

A striking fact about the structure of the industry in the United States is its persistent fewness of incumbents. There have never been more than five general-purpose bond rating firms; currently there are only three. Network effects—users’ desires for consistency of rating categories across issuers—are surely part of the explanation. But, for the past 26 years, regulatory restrictions (by the Securities and Exchange Commission) on who can be a “nationally recognized statistical rating Organization” (NRSRO) have surely also played a role.

A curious part of the behavior of the rating firms is their coverage and their pricing. Hypotheses to explain this behavior are explored.

Although only limited information on profitability is available, it appears that bond rating is quite profitable. A growing regulatory demand for ratings (for safety-and- soundness regulation by bank regulators, insurance regulators, pension fund regulators, and securities regulators) and a regulatory limitation on supply surely are contributory factors. The BIS proposals, if adopted, will accentuate these trends for the United States and other industrial countries.

There is an alternative to these growing regulatory pressures. It would involve the safety-and-soundness regulators’ becoming more directly involved in regulatory judgments, rather than abdicating these judgments to private sector bond rating firms. The SEC, and its counterparts abroad, could then vacate their roles as the certifier of credit rating firms.

These suggestions do not mean that credit rating firms should be prevented from playing a continuing role in helping issuers and investors pierce the fog of asymmetric information in financial markets. But that role should be determined by the market participants themselves, not by additional regulation that artificially increases demand and restricts supply. The latter is a recipe for shortages, rents, distortions, and stifled innovation. This is not a welcome prospect.

Credit ratings pose an interesting paradox. On one hand, credit ratings are enormously valuable and important. Rating agencies have great market influence and even greater market capitalization. Credit rating changes are major news; ² rating agencies play a major role in every sector of the fixed income market. Credit ratings purport to provide investors with valuable information they need to make informed decisions about purchasing or selling bonds, and credit rating agencies seem to have impressive reputations. The market value of credit ratings was confirmed on September 30, 2000, when Moody’s Corp. became a free-standing publicly-traded entity. The market capitalization of Moody's as of April 2002 was more than $6 billion.

Professor Sylla’s paper (Chapter 1, “A Historical Primer on the Business of Credit Rating”) is an excellent overview of the causes of the rise of the rating agencies. He ties it to the investment banks’ loss of credibility as certifiers of bond quality, and the proliferation in the number of issues. Of course, I am pleased that he has given some exposure to my own thesis about ratings as a cost-effective monitoring process. That, I can tell you, is the result many years of thinking about the problem of the role of the rating agencies and the economic basis for them.

Each of these three papers evaluates how external analysts can help an institution assess the condition of its counterparties. The Smith-Walter paper (Chapter 12, “Rating Agencies: Is There an Agency Issue?”) and the White paper (Chapter 2, “The Credit Rating Industry: An Industrial Organization Analysis”) reach dramatically different conclusions about essential features of the credit rating process. These differences have extremely important implications for on-going revisions to the 1988 Basel Accord on bank capital regulation. The Barron-Staten paper (“The Value of Comprehensive Credit Reports: Lessons from the United States Experience”) stands Somewhat apart from the other two, so I will treat it first.¹

This paper examines two specific aspects of the Basel Committee’s proposed reforms to the 8% risk-based capital ratio. We argue that relying on “traditional” agency ratings could produce cyclically lagging rather than leading capital requirements, resulting in an enhanced rather than reduced degree of instability in the banking and financial system, the so-called “procyclicality” problem. Despite this possible shortcoming, we believe that sensible risk based weighting of capital requirements is a step in the right direction. The various standardized risk based bucketing proposals of June 1999 and January 2001, which are tied to external agency ratings, or possibly to internal bank ratings, however, lack a sufficient degree of granularity. In particular, we argue that in Basel’s first proposal of June, 1999, lumping A and BBB (investment grade corporate borrowers) together with BB and B (below investment grade borrowers) severely misprices risk within that bucket and calls, at a minimum, for that bucket to be split into two. After the revisions in early 2001, we acknowledge the improved risk bucket guidelines, but still conclude that several of the new rating categories carry underweighted capital requirements and that banks may continue to be motivated to skew their portfolios toward lower rated loans. We examine the default loss experience on corporate bonds for the period 1981–1999 and propose a revised weighting system which more closely resembles the actual loss experience on credit assets. Later tests include the heightened default experience in 2000.

Resampling implementation of a stress-scenario approach to estimating portfolio default loss distributions is proposed as the basis for estimates of the appropriate absolute level of economic capital allocations for portfolio credit risk. Estimates are presented for stress scenarios of varying severity and implications of different time horizons are analyzed. Results for a numeraire portfolio are quite sensitive to such variations. Although the analysis is framed in terms of recent proposals to revise regulatory capital requirements for banks, the arguments and results are also relevant for bankers making capital structure decisions.

This paper examines the credit ratings assigned to Japanese non-financial corporations by Japanese and foreign rating agencies. More of the variance in Japanese than foreign agency ratings can be explained using financial ratios and a few dummy variables. Credit ratings are closely related to market-determined credit spreads, effectively supplementing the information content of financial indicators in the pricing of corporate risk in Japan. The market appears to take the ratings of both Japanese and foreign agencies into account when pricing the debt of Japanese corporations, for a combination of both Japanese and foreign ratings predicts spreads more precisely than any single set of ratings.

We explore for individual banks, active in the East Asian countries during the years 1996–1998, the performance of three sets of indicators of bank fragility that can be computed from publicly available information: accounting data, stock market prices, and credit ratings. We find significantly different patterns among the three groups of indicators both in their ability of forecasting financial distress at a specific point in time and over time. More specifically, in the South East Asia crisis episode the information based on stock prices or on judgmental assessments of credit rating agencies did not outpace backward looking information contained in balance sheet data. Stock market based information, though, has responded more quickly to changing financial conditions than ratings of credit risk agencies. Overall, the evidence supports the policy conclusion that, where the information processing is quite costly, as in most developing countries, it is important to use simultaneously a plurality of indicators to assess bank fragility.

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.

Each of these excellent papers makes imaginative use of data reflecting actual credit loss experience to illuminate different features of the Basel Committee’s new proposal for risk-adjusted capital requirements (Basel II). Altman and Saunders (A&S, 2002) use default data on publicly traded bonds to investigate the relative risk weights for credit risk. Carey (2002) uses similar data over historical credit cycles to calibrate a model that can gauge whether absolute level of capital requirements is appropriate. I will review each contribution in turn and conclude with some additional questions about the new Basel proposal. But first, a bit of background about how international capital requirements have evolved.

The three papers I will discuss share a common approach to the data; each looks at an aspect of rating agency evaluations using firm level data. However, they also share another common thread in that each has something important to say about the use of rating agency evaluations for bank supervisory purposes. The Altman and Saunders (2002a) paper directly addresses the use of ratings by examining the extent to which the Basel Bank Supervisors Committee’s proposed new capital accord incorporates the historical loss experience by ratings category. Bongini, Laeven and Majnoni (2002) evaluates the merits of using agency ratings of banks in East Asia during the 1995–98 period relative to the use of accounting data and implied fair values of deposit insurance from bank returns. Packer (2002) alone does not explicitly address bank regulatory questions in his paper comparing the ratings assigned to Japanese corporations by the Japanese rating agencies with those assigned by their principal foreign competitors. Nevertheless, if Packer’s interpretation of the reason for the differences is correct; that has important implications for bank supervisor’s use of ratings.

Lest we in academia fear that our musings fall on deaf ears, the work of Altman and Saunders seems to have had a discernible public policy impact. As per the earlier suggestions of Altman and Saunders (2001), the January 2001 revisions to the proposed Basel Capital Accord feature an additional corporate risk bucket in the Standardized Approach.

Financial market instability has been the focus of attention of both academic and policy circles, with rating agencies being singled out as one of the culprits in fueling financial excesses. This paper examines whether sovereign ratings trigger turmoil in emerging markets. Our results indicate that rating changes contribute to market instability through three channels. First, they directly affect stock and bond markets of the countries being rated. Second, they contribute to contagion, triggering instability around the globe. Third, financial markets in countries with lower ratings are more affected by the fluctuations in international financial markets. Still, the effects are small.

Sovereign credit ratings play a crucial role in determining the terms and the extent to which countries have access to international capital markets. Some studies have found that changes in credit ratings have a significant impact on sovereign bond yield spreads.¹ Sovereign credit ratings are supposed to serve as a summary measure of a country’s likelihood of default. Upon a casual inspection of the sovereign credit ratings of a cross-section of countries, it is therefore not surprising to find that the countries with the lowest ratings are those that are unable to borrow from the international capital market altogether and depend on official loans from multilateral institutions or from individual governments. The sovereign rating also influences the terms at which the private sector can borrow from international sources.

Equity risk premiums are a central component of every risk and return model in finance. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. In the standard approach to estimating equity risk premiums we use historical returns, with the difference in annual returns on stocks and bonds over a long time period comprising the expected risk premium. We note the limitations of this approach, even in markets like the United States, which have long periods of historical data available, and its complete failure in emerging markets, where the historical data tends to be limited and noisy. We suggest ways in which equity risk premiums can be estimated for these markets, using a base equity premium and a country risk premium. Finally, we suggest an alternative approach to estimating equity risk premiums that requires no historical data and provides updated estimates for most markets.

The notion that risk matters, and that riskier investments should have a higher expected return than safer investments, to be considered good investments, is intuitive. Thus, the expected return on any investment can be written as the sum of the riskfree rate and an extra return to compensate for die risk. The disagreement, in both theoretical and practical terms, remains on how to measure this risk, and how to convert the risk measure into an expected return that compensates for risk. This paper looks at the estimation of an appropriate risk premium to use in risk and return models, in general, and in the capital asset pricing model, in particular.

This paper examines the potential for conflicts of interest in the debt ratings business. Inherent in the current business model is the fact that firms whose obligations are rated by the agencies pay fees for those ratings, which in turn comprises virtually all of the revenues of the rating agencies. Given the public nature of the ratings, no other business model seems feasible for rating agencies as commercial ventures, so that conflicts of interest are inherent in this important part of the financial markets infrastructure. This paper examines the nature of this conflict, how it is managed, and the significance of market structure and reputation in preventing conflict exploitation. These issues are linked to the use of ratings for regulatory certification purposes, as well as the international dimensions of debt ratings activity through investments and joint ventures of the major rating groups.

The recent debate on the pro-cyclical effects of capital regulation has so far overlooked the important role that bank loan loss provisions and reserves play in the overall minimum capital regulatory framework. This paper suggests that recent advances in the techniques for assessing borrowers creditworthiness make it possible to extend risk-based regulation to loan loss reserves—coherently with the approach taken for bank minimum capital requirements—with beneficial cyclical effects. Notwithstanding its analytically viability a risk-based regulation of bank loan loss provisions may not be easy to implement due to the presence of relevant agency problems between bank stakeholders. We find empirical support for our hypotheses over a sample of 1,176 large commercial banks, 372 of which from non-G10 countries, over the period 1988–1999. After controlling for different country specific macroeconomic and institutional features, we find robust evidence of a differentiated cyclical pattern among G10 and non-G10 countries. While, on average, banks located in G10 countries showed a positive relation between operating income and provisions, the reverse appeared to hold for non-G10 banks.

Let me begin by noting that Moody’s broadly supports the proposals contained in the New Basel Capital Accord and commends the Basel Committee on Banking Supervision for its efforts. We believe that these requirements will promote greater efficiency and stability in the international financial markets by expanding the range of risks subject to systematic measurement, by refining the risk weights applied to bank assets, and by rewarding greater sophistication in risk management practices

Recent advances in modelling credit risk bring much greater discipline to the pricing of credit risk and should promote diversification by penalizing concentrations of credit risk with greater allocations of economic capital. Although these models perform well with regard to high-frequency hazards, they are ill equipped to deal with the low-frequency, high-severity events that are likely to be the most serious threat to financial stability. Cognitive biases in estimating the probability of such losses may lead to disaster myopia. In periods of benign financial conditions, disaster myopia is likely to lead to decisions regarding allocations of economic capital, the pricing of credit risk, and the range of borrowers who are deemed creditworthy, that make the financial system increasingly vulnerable to crisis. Alternative policy measures to counter disaster myopia are considered.