Are Ratings Consistent with Default Probabilities?: Empirical Evidence on Banks in Emerging Market Economies

Abstract

The role of agency ratings as a market-disciplining device, through the production of information on default risk, should grow within Pillar 3 of the Basel II reform. For the role to be efficient, the rating must be effectively consistent with the counterpart's default probability, particularly for emerging markets, where less-developed financial markets, banking-sector accrued opacity, and an inadequate regulatory, institutional, and legal environment affect banks' risk-taking behavior and therefore default risk. This paper uses scoring and mapping methods to study the consistency of bank ratings with their default probabilities in emerging market economies. Results show a correct quantification of agency rating grades, and thus, their consistency. However, mapping results also show that the rating tends to aggregate banks' default risk information into intermediate-low rating grades.

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