Discretionary Credit Rating and Bank Stability in a Financial Crisis

This article studies the incentives for discretionary credit risk assessment under current banking regulations. We use Slovenian data on the credit ratings of nonfinancial enterprises and analyze their reliability as predictors of corporate default to test whether banks in financial distress systematically underestimate credit risk. Our results show that the predictive accuracy of credit ratings deteriorated during the Great Recession both in absolute terms and relative to the benchmark econometric model that uses publicly available data only. Predictive accuracy was lowest for domestically owned banks and, within this group, for small banks. These results can be linked to incentives to underestimate credit risk due to exposure to nonperforming loans and the limitations on raising additional capital. Given that credit ratings are closely related to loan-loss provisions, our analysis indicates that underestimation of credit risk served to inflate banks' books. These findings can rationalize the results of the comprehensive review of the Slovenian banking system in 2013, which revealed significant capital shortfalls, on average, but also significant differences in capital shortfalls across groups of banks with different incentives to underestimate risk. Robustness checks confirm the validity of our conclusions. Our findings provide a plausible explanation for the results of a similar comprehensive review in the euro area prior to the launch of the Single Supervisory Mechanism in 2014.