Is there Cyclical Bias in Bank Holding Company Risk Ratings?

Abstract

Outside monitors provide important information that can help stockholders, creditors, regulators and other stakeholders apply market discipline. In the banking industry, government examiners are an additional outside monitor but with one important difference: bank examination ratings are not public information, and are known only to top bank managers. Still, exam ratings directly influence bank operations and performance because they are used to determine banks' required capital and banks' deposit insurance premiums and, in extreme cases, can constrain banks' investment decisions. Because of banks' special role in the economy, changes in exam ratings can have implications for credit availability and economic growth. Unlike corporate bond ratings - which by design attempt to measure steady state credit worthiness across the business cycle - bank exam ratings are designed to reflect bank safety and soundness at a given point-in-time. Indeed, we find that exam ratings for U.S. banking companies exhibit a much greater volatility, although they are correlated with, bond ratings for U.S. banks. Much of this volatility coincides with the contemporaneous phase of the business cycle. However, in a model that controls for bank characteristics, financial market conditions, past supervisory information, and aggregate macroeconomic factors, we find that bank exam ratings exhibit inter-temporal characteristics. First, exam ratings exhibit some examiner bias - which we define as a significant and persistent deviation of our forecasted changes in upgrades, downgrades and no changes from those actually assigned - for most periods analyzed. When the business cycle turns, examiners often depart from standards that they set during the previous phases of the business cycle. However, this bias is not widespread or systematic. Second, exam ratings exhibit some stickiness. In marginal cases, our results suggest that examiners rate on the side of not changing (rather than upgrading or downgrading) an institution's exam rating. Third, we find strong and robust evidence of a secular trend towards more stringent examination ratings standards over time.

Keywords: Bank Holding Company Risk Ratings, Cyclical and Secular Trends in Bank Risk Ratings

JEL Classification: G21