Credit Ratings and Bank Monitoring Ability

Abstract

In this paper we use credit rating data from two large Swedish banks to elicit evidence on banks’ loan monitoring ability. For these banks, our tests reveal that banks’ credit ratings indeed include valuable private information from monitoring, as theory suggests. However, our tests also reveal that publicly available information from a credit bureau is not efficiently impounded in the bank ratings: The credit bureau ratings not only predict future movements in the bank ratings but also improve forecasts of bankruptcy and loan default. We investigate possible explanations for these findings. Our results are consistent with bank loan officers placing too much weight on their private information, a form of overconfidence. To the extent that overconfidence results in placing too much weight on private information, risk analyses of the bank loan portfolios in our data could be improved by combining the bank credit ratings and public credit bureau ratings. The methods we use represent a new basket of straightforward techniques that enable both financial institutions and regulators to assess the performance of credit rating systems.

Keywords: Monitoring, banks, credit bureau, private information, ratings, regulation, supervision, overconfidence

JEL Classification: D82, G18, G21, G24, G32, G33