Working Paper: CEPR ID: DP9171
Authors: Harald Hau; Sam Langfield; David Marqus Ibaez
Abstract: 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 help 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.
Keywords: conflicts of interest; credit ratings; prudential regulation; rating agencies; sovereign risk
JEL Codes: E44; G21; G23; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Larger banks (G21) | More favorable ratings (C52) |
| Conflicts of interest (G34) | Upwardly biased ratings (G24) |
| State of financial system (G21) | Ordinal rating quality shortfall (L15) |