Assessing the Quality of Bank Loan Ratings

Abstract

As opposed to the public debt market, the ultimate users of bank loan ratings, lenders, may prefer inflated ratings to reduce their risk-weighted assets. By exploiting variation in borrower information asymmetry, and thus rating agencies' ability to acquiesce to lender demands, we provide evidence of whether ratings assigned on private bank loans are reliable indicators of borrower distress. We find that bank loan ratings are systematically biased upwards for bank borrowers with greater information asymmetry. We also find that bank loan ratings are less responsive to changes in underlying credit conditions for borrowers with greater information asymmetry, implying that rating agencies stray away from hard information when formulating ratings for these borrowers. Bank loan ratings are downgraded less often for borrowers with greater information asymmetry, while no difference exists for upgrades. In addition, ratings and ratings changes for high information asymmetry borrowers are less predictive of subsequent loan default. The Basel Accords allow banks to condition capital allocation on borrowers' credit ratings. Our study cautions against this practice.

Keywords: credit risk, credit rating agencies, private firms

JEL Classification: K00, G24, M40