Bank ratings: what determines their quality?

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

Bank ratings: what determines their quality?

This paper examines the quality of credit ratings assigned to banks by the three largest rating agencies. 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 on average large banks receive more positive bank ratings, particularly from the agency to which the bank provides substantial securitization business. 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. — Harald Hau, Sam Langfield and David Marques-Ibane

ESBies: safety in the tranches

It is well known that rational bubbles can be sustained in balanced growth path of a deterministic economy when the return to capital r is equal to the growth rate g. When there is a lack of stores of value, bubbles can implement an e¢ cient allocation. This paper considers a world where r áuctuates over time due to shocks to the marginal productivity of capital. Then, bubbles further e¢ ciency, though they cannot implement Örst best. While bubbles can only be sustained when r = g in a deterministic economy, r > g "on average" in a stochastic economy. Fiscal policy improves welfare by adding an extra asset. Where only the elderly contribute to shifting resources between investment and consumption in a bubbly economy, Öscal policy allows part of that burden to be shifted to the young. Contrary to common wisdom, trade in bubbly assets implements intergenerational transfers, while Öscal policy implements intragenerational transfers. Hence, while bubbles and Öscal policy are perfect substitutes in the deterministic economy, Öscal policy dominates bubbles in a stochastic economy. For plausible parameter values, a higher degree of dynamic ine¢ ciency should lead to a higher sovereign debt

Bank Ratings: What Determines Their Quality?

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

Towards a More Resilient Euro Area. Ideas from the 'Future Europe' Forum. CEPS Paperback, 18 June 2018

Much progress has been made in improving resilience of the single currency since the beginning of the crisis. But many important issues remain to be tackled. The leaders of euro-area member states are expected to use the European Union Summit on 28-29 June 2018 to take preliminary decisions about which additional reforms to pursue. The run-up to this meeting saw a lively debate involving economists and policymakers, albeit against a backdrop of rising Euroscepticism among and waning trust between European partners. ESMT and the German Council of Economic Experts (GCEE) initiated the ‘Future Europe’ forum in the summer of 2017, aiming to bring together a high-level group of economists to discuss economically sensible, legally sound, and politically feasible concepts that deserved to be taken forward. By offering a forum for discussion, we hoped to foster constructive dialogue. They chose an innovative video-conference format to bring experts together face to face without them having to leave their desks (or living rooms). Some 30 economists took part in a dozen such virtual meetings, and their contributions culminated in a publication, brought out jointly by the Centre for European Policy Studies (CEPS), ESMT and the GCEE. The ebookTowards a More Resilient Euro Area: Ideas from the ‘Future Europe’ forum gathers summaries of these economists’ proposals and the discussions they sparked. The main aim was not to produce a variant of the jointly-authored academic paper, but to foster a lively debate between economists who – as one participant put it – “agree somewhat, but not too much”. The publication as a result combines essays outlining an individual author’s thoughts with summaries of the informed, impassioned, and always respectful discussions during each forum. While each contribution can only be attributed to the respective author, each idea and thought is a valuable input that deserves to be considered by European governments as they set about the next euro-area reforms

Regulating the doom loop

Euro area governments have committed to break the doom loop between banks and sovereigns. But policymakers disagree on how to treat sovereign exposures in bank regulation. Our contribution is to model endogenous sovereign portfolio reallocation by banks in response to regulatory reform. Simulations highlight a tension between concentration and credit risk in portfolio reallocation. Resolving this tension requires regulatory reform to be complemented by an expansion in the portfolio opportunity set to include an area-wide low-risk asset. By reinvesting into such an asset, banks would reduce both their concentration and credit risk exposure