Credit rating agency Moody recently released its reports, two important question that come to the fore after: Why is it important for credit rating agencies to grade banks? So what will happen if banks are graded and why should the outcome be made public.
Grading of banks are carried out time to time to determine, whether banks have sufficient capital to sustain themselves in the event of an economic crisis. The findings need to be made public, so that market discipline is maintained at all costs. It would give a clear picture to the outsider about the risks associated with the banks. On the other hand, it would deter banks from biting more than they can chew. By revealing grading results, efficacy of regulations and the role of regulators would also be brought under public scrutiny. However, these benefits would stand annulled unless the ratings are not correctly handled.
Banks have several opaque portfolios that just cannot be evaluated by standard ways. Most of such assessments do not take these portfolios into account. Bank’s invariably choose, to showcase portfolios that would enable them pass the test.
Two renowned economists have devised a few recommendations to make such tests fool proof.
Economists believe that to ensure better market discipline it should be mandatory for banks to make a detailed disclosures of asset class, country and maturity. This would enable market to evaluate the bank’s risk exposure all by itself. If this isn’t possible, then the agencies should disclose the combined results across the banks. This would bring down perverse incentives and at the same time ensure financial stability. Also the rules of grading should not be made known to banks. This would make it hard for the banks to guess the game. Revealing the grades may also lead to overreaction. More often than not the reaction spreads like jungle fire. Unfortunately the reaction may not be well founded. To avert such happenings, every diagnosis should be followed with the right prescription. This wouldn’t check panic and in turn obviate short term panic.
It makes perfect sense to reveal individual bank results only when the results are reliable and accurate. If the objective is to promote market stability, there cannot be a better alternative.