Credit ratings, private information, 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’ internal credit ratings indeed include valuable private information from monitoring, as theory suggests. Banks’ private information increases with the size of loans. However, our tests also reveal that publicly available information from a credit bureau is not efficiently impounded in the bank ratings: credit bureau ratings predict future movements in bank ratings and improve forecasts of both bankruptcy and loan default. The inefficiency of bank ratings is greater for smaller loans. 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. Risk analyses of the loan portfolios in our data could thus be improved by combining the bank credit ratings with 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.