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Modelling the Economic Value of Credit Rating Systems

by Rainer Jankowitsch of Vienna University of Economics and Business Administration, and
Stefan Pichler of Vienna University of Economics and Business Administration

March 2005

Abstract: In this paper we develop a model of the economic value of a credit rating system. Increasing international competition and changes in the regulatory framework driven by the Basel Committee on Banking Supervision (Basel II) called forth incentives for banks to improve their credit rating systems. An improvement of the statistical power of a rating system decreases the potential effects of adverse selection, and, combined with meeting several qualitative standards, decreases the amount of regulatory capital requirements. As a consequence, many banks have to make investment decisions where they have to consider the costs and the potential benefits of improving their rating systems. In our model the quality of a rating system depends on several parameters such as the accuracy of forecasting individual default probabilities and the rating class structure. We measure effects of adverse selection in a competitive one-period framework by parametrizing customer elasticity. Capital requirements are obtained by applying the current framework released by the Basel Committee on Banking Supervision. Results of a numerical analysis indicate that improving a rating system with low accuracy to medium accuracy can increase the annual rate of return on a portfolio by 30 to 40 bp. This effect is even stronger for banks operating in markets with high customer elasticity and high loss rates. Compared to the estimated implementation costs banks could have a strong incentive to invest in their rating systems. The potential of reduced capital requirements on the portfolio return is rather weak compared to the effect of adverse selection.

JEL Classification: G28, C13.

Keywords: Rating system, cohort method, Basel, banking regulation, capital requirements, probability of default, adverse selection.

Published in: Journal of Banking & Finance, Vol. 31, No. 1, (January 2007), pp. 181-198.

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