amount of heterogeneity within each rating class, since a single letter grade is used to
represent a multidimensional concept that includes default probability, loss severity,
and transition risk. Moreover, since ratings agencies try to avoid discrete jumps in rat-
ings classifications, the rating may be a lagging, not a leading indicator of credit qual-
ity (see Reisen and von Maltzan (1999) and Reinhart (2001) for discussions of lags in
sovereign credit ratings, Kealhofer (2000) and Altman and Saunders (2001a) for lags
in publicly traded corporate ratings, and Bongini et al. (2001) for lags in credit ratings
of banks). As ratings change over time, the transaction may be shifted from one risk
bucket to another, thereby injecting excessive volatility into capital requirements (see
Linnell (2001)) and may lead to an increase in systemic risk since, with increased
downgrades in a recession, banks may find their capital requirements peaking at the
worst time (i.e., in the middle of a recession when earnings are relatively weak). In-
deed, there is evidence (see Ferri et al. (2001), Monfort and Mulder (2000), Altman
and Saunders (2001a)) that ratings agencies behave procyclically since ratings are
downgraded in a financial crisis, thereby increasing capital requirements at just the
point in the business cycle that stimulation is required (see Reisen (2000)). Thus, peg-
ging capital requirements to external ratings may exacerbate systemic risk concerns.
Concern about systemic risk may lead to regulatory attempts to influence ratings agen-
cies, thereby undermining their independence and credibility.^30 (See Allen and Saun-
ders (2002) for a survey of cyclical effects in credit risk measurement models.)
Although an important advantage of external ratings is their validation by the mar-
ket, the credit rating industry is not very competitive. There are only a handful of
well-regarded rating agencies. This leads to the risk of rating shopping.^31 Since the
obligors are free to choose their rating agency, moral hazard may lead rating agen-
cies to shade their ratings upward in a bid to obtain business. Moreover, since there
is no single, universally accepted standard for credit ratings, they may not be com-
parable across rating agencies and across countries. (See discussions in White (2001),
Cantor (2001), Greip and De Stefano (2001).) This is likely to distort capital re-
quirements more in less developed countries, because of greater volatility in less de-
veloped countries (LDC) sovereign ratings, less transparent financial reporting in
those countries, and the greater impact of the sovereign rating as a de facto ceiling
for the private sector in LDCs.^32
Finally, banks are also considered “delegated monitors” (see Diamond (1984))
who have a comparative advantage in assessing and monitoring the credit risk of their
borrowers. Indeed, this function is viewed as making banks “special.” This appears
to be inconsistent with the concept underlying the Standardized Model, which essen-
tially attributes this bank monitoring function to external rating agencies for the pur-
poses of setting capital requirements. Adoption of this approach may well reduce
bank incentives to invest time and effort in monitoring, thereby reducing the avail-
ability of information and further undermining the value of the banking franchise.
3.3 ASSESSMENT 3 • 9(^30) Moreover, the usefulness of external ratings for regulatory purposes is questionable since the rating
incorporates the likelihood that the firm will be bailed out by the government in the event of financial dis-
tress. Only Fitch IBCA and Moody’s provide stand-alone creditworthiness ratings, but these cannot be
used to calculate the probability of default (PD); see Jackson et al. (2001).
(^31) Jewell and Livingston (1999) find that Fitch ratings are slightly higher on average than ratings from
S&P and Moody’s. Fitch is the only rating agency that explicitly charges for a rating.
(^32) Moreover, contagious regional financial crises in confidence may lead to excessive downgradings of
sovereign ratings, see Cantor and Packer (1996), Ferri, et al. (2001), and Kaminsky and Schmukler (2001).