Effect on Financial Stability

Rating agencies contribute to enhancing financial stability through two channels. First, by summarizing a large and diverse amount of information for the benefit of investors and by acting as a monitor of default prospects and default events, rating agencies provide market incentives for improved governance by issuers. Second, bank regulators increas­ingly use rating information in assessing capital adequacy. The standardized approach of the New Basel Capital Accord spells out six criteria that supervisors can use to evaluate external credit assessment institutions before allowing their ratings to be used as the basis for assigning risk weights on banks’ exposures.

The recognition criteria consist of (a) objectivity (use of rigorous rating methodol­ogy that is subject to validation and back testing); (b) independence (free-form political or industry pressures); (c) international access and transparency of assessments (ratings should be disclosed and should be available to both domestic and international investors); (d) disclosure (of assessment methodology, including definition of default, time horizon, and the meaning of each rating); (e) resources (sufficient to carry out high-quality assess­ments); and (f) credibility (wide acceptance and integrity of the process). See Basel Committee on Banking Supervision (2004).

Rating agencies may weaken financial stability through the effect of rating changes on market perceptions. Recent experience has also highlighted that “procyclical” behavior of ratings agencies may have contributed to financial instability because of asset price chang­es arising from upgrading in good times and downgrading in bad times; rating changes also have significant spillover effects on other asset markets, including in neighboring developed and developing countries (Kaminsky and Schmuckler 2002).

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