How Rating Analysts' Subjective Judgements Affect Bank Credit Ratings

Abstract

The proper functioning of the asset markets is based on reasonable expectations. Yet how can investors, who may need the expertise, form expectations of the future? Therefore, credit ratings (CR) provided by credit rating agencies (CRA) play a critical role in such an expectation formation process. Yet CRA has been challenged after the 2008 financial turmoil, and significant changes have been made. Today, CR is still widely applied by market practitioners and regulators. For example, asset management companies, particularly life insurance companies, use CR in their investment guidelines to determine if their portfolio managers can invest in specific fixed-income instruments. The regulators use CR to determine the capital requirements of regulated entities, such as Basel's External Credit Risk Assessment Approach (ECRA) for banks.

This study examines 687 Fitch-rated banks in 61 economies from 2014 to 2021, the post-2008 financial turmoil period, where additional regulations were implemented to provide more transparency on the rating processes and the factors considered in the rating criteria. I focus on the often-overlooked CR breakdown, namely objective ratings and subjective adjustments. The Basel Committee also emphasized that banks should not systematically rely on external ratings and should understand the "breakdown" of the components and underlying drivers of the ratings.

In practice, the objective ratings are mainly based on the following five aspects: operating environments, asset quality, earnings and profitability, capitalization and leverage, and funding and liquidity. Then, the rating analysts will adjust the rating from the rating criteria, driven by publicly released fundamentals, and present them to the rating committees, which may include their confidential information shared by the issuers to the CRA and the rating analysts' forecast.

In this study, I document a robust and negative correlation between the objective ratings and subjective adjustments, which leads to a relatively stable final rating over time. Yet, how would the subjective adjustments offset the movements in objective ratings? I provide an intuitive explanation. Banks go through business cycles. With fixed rating metrics of the core financial variables, the objective ratings naturally display cyclical movement, which may not reflect the "true standing" of the banks. Rating analysts, therefore, exercise their informed authority and correct for the mechanical movement through their subjective rating assessment, leading to a relatively stable overall rating of banks.

My results carry important implications. Empirically speaking, the time series of subjective rating adjustments will likely reflect this offsetting behavior, and researchers might conclude that emotional adjustments have no predictive power for banks' future financial conditions that the market players may expect.

I concluded that asset quality and capitalization & leverage are two key aspects reflecting analysts’ subjective adjustments on the final credit ratings.

Date of Award	28 Aug 2024
Original language	English
Awarding Institution	City University of Hong Kong
Supervisor	Ka Yui Charles LEUNG (Supervisor)