Emerging Markets Finance and Trade

ISSN: 1540-496X (Print) 1558-0938 (Online) Journal homepage: http://www.tandfonline.com/loi/mree20

Are Ratings Consistent with Default Probabilities?:

Empirical Evidence on Banks in Emerging Market
Economies

Christophe J. Godlewski

To cite this article: Christophe J. Godlewski (2007) Are Ratings Consistent with Default
Probabilities?: Empirical Evidence on Banks in Emerging Market Economies, Emerging Markets
Finance and Trade, 43:4, 5-23

To link to this article: http://dx.doi.org/10.2753/REE1540-496X430401

Published online: 07 Dec 2014.

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 Emerging Markets Finance and Trade, vol. 43, no. 4,
July–August 2007, pp. 5–23.
© 2007 M.E. Sharpe, Inc. All rights reserved.
ISSN 1540–496X/2007 $9.50 + 0.00.
DOI 10.2753/REE1540-496X430401

CHRISTOPHE J. GODLEWSKI
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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.

Key words: bank rating, default probability, emerging market economies, market discipline,
scoring and mapping methods.

Can agency ratings be considered good indicators of a counterpart’s default risk?

There is little consensus regarding ratings’ capacity to provide superior information

Christophe J. Godlewski (godlewski@cournot.u-strasbg.fr) is an assistant professor of

finance for LaRGE, Faculté des Sciences Economiques et de Gestion, Université Louis Pas-
teur, Strasbourg. The author thanks Michel Dietsch, Maxime Merli, Franck Moraux, Laurent
Weill, two anonymous referees, and the organizers and the participants of the International
Conference AFFI, Université Cergy Pontoise, France, June 24–26, 2004.

5
 6 EMERGING MARKETS FINANCE AND TRADE

compared to financial markets (see, e.g., Ederington et al. 1987; Hand et al. 1992;
Helwege and Turner 1999; Reiter and Zeibert 1991), and the empirical study of
bank fragility in Southeast Asia by Bongini et al. (2002) shows that ratings are the
less discriminating and predictive indicators of distress compared to accounting
and financial market data.
However, the specificity of the rating as a device to provide synthetic informa-
tion to investors and regulators is very useful, as it contributes to market discipline.
Ratings are supposed to produce a measure of default probability for financial and
nonfinancial companies. The role is even more crucial in emerging market econo-
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mies because the regulatory and institutional environment tends to create adverse
incentives for risk taking, which needs to be counterbalanced by stronger market
discipline (Rojas-Suarez 2000; 2001).
The consistency of banks’ ratings with their default probabilities is fundamental
in this context, as it shapes proper incentives to adopt prudent risk-taking behavior.
Consistency between bank rating and default risk is a viable signal of a bank’s
soundness, allowing the market to exert its disciplining role with more power.
Thus, the banker is incited to adopt conservative risk-taking behavior, as excess
risk increases the default probability and downgrades the bank rating.1
Recently, several studies have investigated the consistency of agency ratings
with default models (e.g., Carey and Hrycay 2001). The results show a satisfactory
consistency of Moody’s ratings with default probabilities obtained with a simple
scoring model, but also put forward several problems linked to bias, instability,
and ratings manipulation. Mechanical bias, related to assigning a counterpart to a
specific rating grade, and informational bias, related to aggregating counterparts
to a specific rating grade, are relatively present. Default probability estimation
methods based on means are more suited to low-quality rating grades quantification,
whereas methods based on medians are more suited to high-quality rating grades
quantification. Mapping and scoring methods are both found to be stable. Güttler
(2004) and Krämer and Güttler (2003) examine the default prediction accuracy
for Standard and Poor’s and Moody’s ratings for different counterparts, industries,
and countries, using nonparametric bootstrapping techniques. They show that both
agencies’ ratings are good predictors, though the Moody’s rating performs slightly
better in accurately predicting default. However, evidence remains scarce concern-
ing ratings’ consistency with default probabilities for banks in emerging market
economies. Additionally, the methodologies cited above are complex and difficult
to implement in practice.
This paper seeks to investigate Moody’s bank ratings’ consistency with the results
of a scoring model in emerging markets, applying the scoring and mapping methods
proposed by Carey and Hrycay (2001). Quantifying Moody’s rating grades using a
scoring method shows a satisfactory level of consistency between the Moody’s Bank
Financial Strength Rating (MBFSR) and the observed default risk in the sample.
However, the results of the mapping method suggest a tendency to aggregate default
risk information into intermediate low–quality rating grades.
 JULY–AUGUST 2007 7

Ratings Systems

Following Crouhy et al. (2001), we suppose that a rating system is based on quan-
titative and qualitative evaluations of the borrower’s solvability. The final decision
concerning the rating is based on economic and financial analysis, as well as on
the subjective judgment and experience of the analyst. Factors such as financial
documents, management quality, competition, and macroeconomic and sector
fundamentals are evaluated during the rating process. Ratings can be interpreted
as informational signals on default probability, as they aim principally to provide
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information on a counterpart’s capacity to fulfill its engagement. Thus, the rating

is a synthetic indicator of the counterpart’s so-called distance to default, and more
broadly, of its default risk. This definition relies on Ferri et al. (1999), who put
forward the fundamental role of the rating agencies in financial markets, providing
information to participants, reducing informational asymmetries, and enhancing
market discipline. The rating also strongly determines the interest rate and number
of potential investors.
Financial and banking markets are more opaque in emerging markets with weaker
market discipline (Allen and Gale 2000). In such a context, the rating has even
more importance and value to investors.2 The regulatory, legal, and institutional
environment might enhance opacity problems but also contribute to excessive
risk-taking incentives for banks (Rojas-Suarez 2000; 2001). The weight of a rat-
ing in an investor’s decision will thus be even stronger in such a context. Rating
disposability gives better visibility, and therefore enhances market transparency
for investors, especially foreign investors.
Several areas of research deal with agency ratings.3 The work related to ratings
transition matrices (Christensen et al. 2004; Lando and Skodeberg 2002; Lucas and
Klaassen 2006; Nickell et al. 2000) is crucial for several reasons. Equity allocation
for value-at-risk coverage is computed with risk models using ratings as inputs, for
which knowledge of future distribution is needed. Default events being rare and rat-
ings historical distributions being rather short, an understanding of ratings transitions
allows for the extrapolation of fitted default probabilities. Ratings transitions also
shed light on the explanatory factors of ratings.4 Nickell et al. (2000) find that factors
such as industry, domiciliation, and business cycle have a significant influence on
Moody’s ratings transition probabilities. Jafry and Schuermann (2004) prove that
the choice of the transition matrix estimation method affects the results.
The determinants and stability of ratings are another important field of research
(Ederington et al. 1987; Kaplan and Urwitz 1979), as investors using the ratings are
concerned with their stability through the credit cycle. Altman and Rijken (2004)
compare observed transitions with computed ones using scoring and rating models,
with different time horizons. Their results show that agency ratings are relatively
stable. Amato and Furfine (2004) find that ratings are weakly sensitive to business
cycle variables.5 Comparing different agency ratings is also an important area of
research (Jewell and Livingston 1999; Shin and Moore 2003), as is research deal-
 8 EMERGING MARKETS FINANCE AND TRADE

ing with the relation between ratings, asset prices and volatility, and spreads. The
results usually show a negative relation between spreads and the rating. Similar
results are obtained for the relation between market information, especially asset
prices (Basçi and Ekinci 2005; Elton et al. 2001; Hull et al. 2004).
Finally, a growing literature deals with the informational capacity of regulatory
ratings as well as market indicators (Berger et al. 2000; Bliss and Flannery 2002;
DeYoung et al. 2001; Kaplan and Lopez 2004). The results remain mitigated, but the
main conclusion advocates for a complementarity between regulatory and market
information. The regulator has access to more precise information and thus might
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increase market discipline.

Methodology and Data

Methodology

Carey and Hrycay (2001) propose an empirical investigation of the proprieties of

two methods of default probability estimation linked to ratings. The work of Carey
and Hrycay (2001) offers several findings regarding rating-grade quantification,
and they investigate several problems related to different quantification methods.
Mechanical bias, related to assigning a counterpart to a specific rating grade, and
informational bias, aggregating counterparts into a specific rating grade, are pres-
ent in both methods. Gaming problems are also investigated, as they might harm
estimation quality if several agents are involved in the rating process. Default
probability estimation methods based on means are more suited to low-quality
rating-grade quantification, and methods based on medians are more suited to high-
quality rating-grade quantification. Mapping and scoring methods are both found
to be stable, though the stability depends on the point in time and the time period
used for estimation. The scoring method may better estimate default probability
as it is easily adjustable to any point in time.
We apply the scoring and mapping methodologies of Carey and Hrycay (2001)
to an emerging markets bank database rated by Moody’s, containing default and
nondefault banks. First, we estimate default probabilities using a logit model. Sec-
ond, we use the estimated default probability distribution to build simulated rating
grades. Third, we quantify the Moody’s ratings grades using the results of the scoring
model. Finally, we map the simulated rating scale to the Moody’s ratings scale and
its respective historical default rates. The methodologies allow us formally to link
default probabilities from a rating system to estimated default probabilities.
More precisely and practically, the methodology can be decomposed into five
steps:

Step 1. We apply a logit model to estimate default probabilities.6 These probabili-

ties are noted pD and correspond to individual default probabilities at a one-year
horizon of the banks in the sample. The scoring model is defined as
 JULY–AUGUST 2007 9

exp v
(
p DEFAULTi,t = ) 1 + exp v

with v = α + Y′i,t–1β + εi,t–1, Y′i,t–1 being the risk factors. The residuals εi,t–1 have a
logistic distribution, with a mean 0 and variance Π2/3. We explain DEFAULT
at time t with one-year lagged risk factors.
Step 2. Using the distribution of probabilities pD, we build simulated rating
grades, following Carey and Hrycay (2001) and Moody’s reports (Hamilton et
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al. 2004), which allows us to assign a simulated rating to each bank. Thus, an
ordinal risk scale is obtained.
Step 3. The following descriptive statistics are calculated: means and medians of
the estimated default probabilities pD, as well as means and medians of observed
default rates in the sample, by simulated rating grade.
Step 4. The same descriptive statistics related to pD and default rates are com-
puted by Moody’s rating grade.
Step 5. We map the simulated rating grades obtained in Step 2 into Moody’s
rating grades. We make a more precise analysis of the consistency investiga-
tion through the mapping of historical default rates corresponding to Moody’s
median ratings with observed default rates in the sample by simulated rating
grade. The consistency is satisfactory if the ratings and simulated ratings dis-
tributions correspond.

Data

The MBFSR, which Moody’s launched in 1995, corresponds to Moody’s opinion

on the internal financial strength of a bank. Based on a financial analysis and a
subjective judgment of the analyst, its determinants are different from traditional
ratings, such as debt, credit, bank deposits, and syndicate loans ratings. The MBFSR
is available for banks from fifty countries, and its grades range from A (best rating)
to E (worst rating). It is available on solicited and unsolicited bases.
The MBFSR can be interpreted as a synthetic indicator of a bank’s default prob-
ability, as it aims to summarize information about a bank’s financial strength. We
also use the Bankscope Fitch IBCA database to extract balance sheet information
for the emerging market banks investigated in this study, along with default banks.
A default bank database has been built for emerging market countries from the
three areas of Southeast Asia, South America, and Central and Eastern Europe.
To get information about default banks, we contacted local regulatory and super-
visory institutions. We also used information from the Banker’s Almanac online
database. Our database allows us to identify the name of the default bank and the
time of default. A bank is considered as default when it is under external admin-
istration—that is, regulatory and restructuring agency support—banking license
suspension or revocation, liquidation, or failure. Table 1 contains the definitions
of the Moody’s ratings.7 Table 2 shows the number and the frequency of banks by
 10 EMERGING MARKETS FINANCE AND TRADE

Table 1

Definition and Frequencies of the Moody’s Bank Financial Strength Rating

MBFSR Observations Definition

A 0 Exceptional intrinsic financial strength

Major institutions with highly valuable franchise value,
strong financial fundamentals, and a very attractive
and stable operating environment
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B 12 Strong intrinsic financial strength

C 57
D 237
E 177
Important institutions, with valuable franchise value,
sound financial fundamentals, and stable operating
environment
Good intrinsic financial strength
Valuable franchise value, acceptable financial fun-
damentals within a stable operating environment,
or above-average financial fundamentals within an
unstable operating environment
Weak intrinsic financial strength
Weak franchise value, financial fundamentals, and an
unstable operating environment
Very weak intrinsic financial strength
Periodic external support is necessary
Doubtful franchise value, deficient financial fundamen-
tals, and a highly unstable operating environment

Sources: Moody’s Investors Service, Global Credit Research; Poon et al. (1999).
Note: This table reports the number of observations for each MBFSR grade in the sample
and a brief definition of each rating grade.

country within the sample. Frequencies of Moody’s BFSR rating, by region and
by year, are shown in Tables 3 and 4, respectively.
South and Central American banks account for almost 50 percent of the sample,
followed by Southeast Asian banks. Almost one-third of the defaults occurred in
1998, their repartition being between 10 percent and 15 percent per year for the
following years.

Results and Discussion

We use a scoring model with five proxies of the main risk factors found in the
literature (see Demirgüç-Kunt 1989), which have a significant effect on banks’
default probability.8 The risk factors are chosen following the results of the study by
Godlewski (2006), the main aim of which was to investigate the validity of CAMEL
(capital, asset quality, management quality, earnings, and liquidity)-type risk fac-
tors for bank default studies in emerging markets. We select the risk factors with
 JULY–AUGUST 2007 11

Table 2

Frequencies of Moody’s BFSR-Rated Banks (by country)

Country Code Number of banks Frequency

Argentina AR 40 8.28
Brazil BR 52 10.77
Colombia CO 23 4.76
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Czech Republic CZ 12 2.48

Ecuador EC 8 1.66
Hong Kong HK 6 1.24
Croatia HR 4 0.83
Indonesia ID 7 1.45
South Korea KR 60 12.42
Latvia LV 10 2.07
Mexico MX 33 6.83
Malaysia MY 20 4.14
Peru PE 23 4.76
Poland PL 46 9.52
Romania RO 12 2.48
Singapore SG 22 4.55
Slovenia SI 2 0.41
Slovakia SK 14 2.90
Thailand TH 47 9.73
Taiwan TW 6 1.24
Venezuela VE 36 7.45
483 100

Note: This table reports the number of rated banks and their frequencies by country in the
sample.

the highest explanatory and discriminatory power using a stepwise procedure.

The CAMEL-type risk factors cover the following dimensions of risk: capital
adequacy (EQUTOTASSETS = equity / total assets), bank loan portfolio quality
(LLOSSRESNPL = loan loss reserves / nonperforming loans), bank management
(PERSEXPENSE = personal expenses / total operating expenses), profitability
(NETINTMARGIN = net interest margin), and liquidity (LIQUIDASSETS =
liquid assets / total assets). We control for bank size by including the logarithm
of total assets as a proxy (LOGTOTASSETS). Table 5 presents descriptive statis-
tics for the risk factors. The mean values of the risk factors for capital adequacy
(EQUTOTASSETS), loan portfolio quality (LLOSSRESNPL), bank management
(PERSEXPENSE), profitability (NETINTMARGIN), and liquidity (LIQUIDAS-
SETS) are much lower for default banks than nondefault banks. Bank size appears
to be relatively equivalent for default and nondefault banks.
 12 EMERGING MARKETS FINANCE AND TRADE

Table 3

Frequencies of Moody’s BFSR (by rating grade and region)

Total
percent
B C D E by region

Latin America 0 34 119 62 215

percent 0 15.81 55.35 28.84 44.52
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Asia 12 13 50 93 168
percent 7.14 7.14 29.76 55.36 34.78
Eastern Europe 0 10 68 22 100
percent 0 10 68 22 20.7
Total 12 57 237 177 483
percent by rating
grade 2.48 11.8 49.07 36.65 100

Note: This table reports the frequencies of the MBFSR by geographical region in the
sample.

Table 4

Number of Rated Banks and Frequencies of Bank Defaults (by year)

Default Number
rate (percent) of rated banks

1998 10.56 51
1999 20.08 97
2000 21.95 106
2001 25.26 122
2002 22.15 107
Total 100 483

Note: This table reports the number of rated banks and the frequencies of bank defaults
by year in the sample.

The descriptive statistics of different balance sheet ratios, particularly their means
for default versus nondefault, are aberrant for small default banks, indicating that
other factors, probably macroeconomic, are the source of the problem. We therefore
bound the variable for total assets to eliminate small banks (total assets > Q1, first
quartile = $105.11 million). The size criterion determines our sample; we then focus
on banks that mainly engage in credit allocation, and therefore, the main source of
risk is credit risk. We thus bound the variables of net loans to total assets and total
 JULY–AUGUST 2007 13

Table 5

Scoring Model Explanatory Variables, Descriptive Statistics

Standard
Variable N Mean deviation Minimum Maximum

Defaults

EQUTOTASSETS 68 0.09 21.68 –120.92 28.26

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LLOSSRESNPL 68 30.03 31.13 7.74 114.91

PERSEXPENSE 68 24.44 11.27 7.02 96.85
NETINTMARGIN 68 0.65 9.45 –52.99 3.78
LIQUIDASSETS 68 16.82 8.59 5.16 39.09
LOGTOTASSETS 68 16.32 0.83 13.58 17.38

Nondefaults

EQUTOTASSETS 415 9.96 6.39 –4.49 59.55

LLOSSRESNPL 415 101.33 93.46 5.25 765.62
PERSEXPENSE 415 35.47 15.64 7.02 96.85
NETINTMARGIN 415 5.89 6.21 –16.95 31.72
LIQUIDASSETS 415 30.92 15.41 5.03 73.79
LOGTOTASSETS 415 15.47 1.15 12.5 18.09

Source: Bankscope.
Notes: This table reports descriptive statistics of the explanatory variables used in the
scoring model in the sample. N = number of observations.

deposits to total assets by eliminating the first percentile (p10 = 25.32 percent of
total assets and p5 = 26.81 percent of total assets, respectively). A second bank’s
activity criterion determines our sample. Finally, we bound the ratio of loan loss
reserves to nonperforming loans to eliminate the outlier, corresponding to the last
p99, which is equal to 448.73 percent.
After having bounded and cleaned the data, we obtain a sample of 478 banks,
covering emerging market economies from Southeast Asia, South America, and
Central and Eastern Europe. Sixty-eight defaults are present in the sample. The
time period investigated is from 1998 to 2002. The results for each of the five steps
of the methodology described above are as follows.

Step 1

Table 6 presents the results of the bank default logit model.

The coefficients of EQUTOTASSETS, LLOSSRESNPL, PERSEXPENSE,
NETINIMARGIN, and LIQUIDASSETS have significant and expected signs,
 14 EMERGING MARKETS FINANCE AND TRADE

Table 6

Bank Default Logit Model Results

Variables Coefficient

INTERCEPT –5.221*
(2.84)
EQUTOTASSETS –0.231***
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(0.07)
LLOSSRESNPL –0.019***
(0.01)
PERSEXPENSE 0.02
(0.01)
NETINTMARGIN –0.192***
(0.01)
LIQUIDASSETS –0.06***
(0.01)
LOGTOTASSETS 0.453***
(0.11)
Number of defaults 68
Number of banks 478
Likelihood ratio 175.97***
Log likelihood –107.54
Default reclassification rate 88.2
Nondefault reclassification rate 83.7

Notes: This table reports the results of the scoring model. The dependent variable is
DEFAULT. Explanatory variables are one year lagged. *** and * are significant coeffi-
cients at 1 percent and 10 percent, respectively. Standard errors are shown in parentheses.

consistent with the results obtained in existing literature (see Demirgüç-Kunt

1989). Better capital adequacy, more important coverage of nonperforming loans
with reserves, stronger ratios of personal expenses, better interest margins, and
more liquid assets all reduce the probability of bank default. The statistics of the
model have significant likelihood ratios, good adjustment quality, and a satisfac-
tory default and nondefault reclassification rate, close to 90 percent and 85 percent,
respectively.

Step 2

We split the estimated default probability interval following Carey and Hrycay
(2001) and Hamilton et al. (2004). However, we aggregate the probabilities into
 JULY–AUGUST 2007 15

Table 7

Four-Grade Simulated Rating System

pD Simulated grade

< 0.0025 1
[0.0025, 0.01] 2
[0.01, 0.05] 3
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≥ 0.05 4

Note: This table reports the cutoff points of the estimated default probability using the
scoring model to define the four simulated rating grades.

four grades as we work on four rating grades for the MBFSR in our sample (B,
C, D, and E). The obtained simulated rating grades, using the estimated default
probabilities interval, are shown in Table 7.9

Step 3

Using the estimated default probability means and medians, we quantify each
simulated rating grade, comparing the results with observed default rates in the
sample by simulated rating grade. Table 8 shows the results.
First, we obtain a monotonic relation between the mean estimated default prob-
abilities and the observed default rates in the sample by simulated rating grade.
Mean estimated default probabilities are relatively consistent with observed default
rates, particularly for the riskiest grade, the fourth, which has a mean estimated
default probability of 34.26 percent and an observed default rate of 32.63 percent.
The consistency is lower for the safest grades, the first and second, for which there
are no observed defaults in the sample. This result is in line with Carey and Hrycay
(2001), as means-based quantification methods are more suited to low rating grades.
The mean and median values of the estimated default probabilities are close. For the
simulated rating grades containing defaults, the mean estimated default probability
values are within the 95 percent confidence interval limits for the observed default
rate, which contribute to validating the consistency level. We also observe that the
standard deviation values for the mean estimated default probabilities increase
with simulated rating grades and are lower than the standard deviations for mean
default rates. The standard deviation gives a measure of default risk homogeneity
by rating grade (simulated and Moody’s), as it is not always guaranteed by the
rating system (see, e.g., Blochwitz and Holh 2001). Finally, except for the first
and second simulated grades that have no observed default, 95 percent confidence
interval limits for the estimated default probability and the observed default rate
are overlapping.
 16 EMERGING MARKETS FINANCE AND TRADE

Table 8

Means and Medians of the Estimated Default Probability and Default Rate
(by simulated rating grade)

Grades

1 2 3 4

Mean 0.000617 0.005808 0.022789 0.34261

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Median 0.000277 0.005237 0.021318 0.279663

Standard error 0.0007 0.0022 0.0114 0.2524
Default rate 0 0 0.046296 0.326316
Default number 0 0 6 62
Default rate
standard error 0 0 0.2111 0.4701
Lower confidence
interval limit
(95 percent) 0.000492 0.005261 0.020617 0.306483
Upper confidence
interval limit
(95 percent) 0.000743 0.006354 0.02496 0.378736
Lower confidence
interval limit,
default rate
(95 percent) 0 0 0.0152 0.2602
Upper confidence
interval limit,
default rate
(95 percent) 0 0 0.1047 0.3979

Notes: This table reports the results of the simulated rating quantification using the
scoring model by simulated rating grade. The estimated default probability using the
logit model is noted as pD. As the number of observations by rating grade (simulated and
Moody’s) is low, we use exact confidence interval limits under the hypothesis of binomial
distribution of the proportions.

Step 4

We now proceed to quantifying Moody’s rating grades using the scoring method,
calculating default probabilities by MBFSR grade using individual default prob-
abilities estimated with the logit model. Table 9 presents mean and median estimated
default probabilities, observed default rates, 95 percent confidence interval limits,
and standard deviations for estimated default probabilities and observed default
rates, by Moody’s BFSR grade.
 JULY–AUGUST 2007 17

Table 9

Means and Medians of Estimated Default Probability and Default Rate (by
MBFSR grade)

MBFSR

B C D E

Mean 0.03125 0.014895 0.074619 0.278786

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Median 0.030338 0.007982 0.011019 0.15315

Standard error 0.0129 0.0209 0.1464 0.2852
Default rate 0 0.036364 0.08547 0.259887
Default number 0 2 20 46
Standard error,
default rate 0 0.188919 0.280179 0.439817
Lower limit,
confidence interval
(95 percent) 0.023062 0.009248 0.05576 0.236481
Upper limit,
confidence interval
(95 percent) 0.039438 0.020543 0.093478 0.321092
Lower limit of default
rate, confidence
interval (95 percent) 0 0.0044 0.053 0.197
Upper limit of default
rate, confidence
interval (95 percent) 0 0.1253 0.1289 0.331

Notes: This table reports the results of the MBFSR quantification using the scoring
model by MBFSR grade. Estimated default probability using the logit model is noted.
As the number of observations by rating grade (simulated and Moody’s) is low, we use
exact confidence interval limits under the hypothesis of binomial distribution of the
proportions.

The rating should be through the cycle by nature, whereas the logit model
estimates a point-in-time default probability. However, if the default model can
correctly estimate individual default probabilities at a horizon of one year, it should
also allow us to estimate correctly the mean default probability by Moody’s BFSR
grade.10
Following the results in Table 9, we conclude in favor of a consistency of mean
estimated default probabilities with observed default rates by Moody’s BFSR grade,
except for grade B, for which no defaults are observed in the sample. The estimated
mean default probabilities are 1.49 percent, 7.67 percent, and 27.88 percent for
grades C, D, and E, respectively, with corresponding default rates at 3.63 percent,
 18 EMERGING MARKETS FINANCE AND TRADE

8.55 percent, and 25.99 percent, respectively. Thus, except for MBFSR grade B,
all of the mean estimated default probabilities are within the 95 percent confidence
interval limits for the default rate. However, except for grade B, the mean and me-
dian estimated default probabilities diverge. The standard deviations of estimated
default probabilities and default rates increase with Moody’s BFSR grades and are
less divergent than the means and medians, suggesting that the MBFSR becomes
less homogenous as the risk increases, which can be explained by a stronger role of
the analyst’s subjective judgement in the rating grade assignment. We also remark
that the 95 percent confidence interval limits for the estimated default probabilities
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and the default rates overlap for the MBFSR grades C, D, and E, allowing us to
validate the consistency results.

Step 5

Finally, we use the default probability, or the one-year transition to the default grade,
of the Moody’s rating grades to map the simulated rating system onto the agency
rating system. Table 10 shows the results. Historical default rates correspond to the
mean historical transition rates to the DEFAULT category at a one-year horizon
over the time period 1998–2002 for the emerging markets in the sample.11
The last simulated grade, the fourth, corresponds to Moody’s BFSR grade E,
whereas the first three simulated grades correspond to the MBFSR grade D. This
may suggest a form of default risk information aggregation by the Moody’s BFSR
rating. We also remark that the historical default rates corresponding to the Moody’s
rating overestimate observed default rates for low-risk simulated grades and under-
estimate observed default rates for high-risk simulated grades. Even for the last and
most risky simulated fourth grade, the historical default rate is 14.29 percent, over
two times lower than the observed default rate for this grade, 32.63 percent. The
value of the historical default rate lies outside the 95 percent confidence interval
limits for each rating grade. The means of the MBFSR are close to 3 for the first
three simulated rating grades, corresponding to grade D for Moody’s. The mean
MBFSR for the last simulated rating grade is 3.6, close to grade E for Moody’s.
The MBFSR’s standard error by simulated rating grade lies between 0.6 and 0.9,
showing the presence of heterogeneity within the rating grades.
Our results are close to Carey and Hrycay (2001) in several aspects. First, regard-
ing the ability of a scoring model to assign and quantify simulated rating grades,
we also find that the estimated sample mean fitted default probabilities are close to
the actual default rates for the high-risk grades (C and D). Second, regarding the
ability of the scoring model to quantify agency rating grades, our results show also
that the means perform better for the risky grades. As to mapping the simulated
rating system onto the Moody’s rating system, our results are slightly different from
Carey and Hrycay (2001) in that they tend to aggregate default risk information
into risky grades; the first three simulated rating grades correspond to a MBFSR
median value of D. This result is partially driven by the quality of the banks in our
sample, which are from emerging market economies and are therefore more risky
 JULY–AUGUST 2007 19

Table 10

Mapping Simulated Ratings into Moody’s Ratings

Grades

1 2 3 4

Median MBFSR D D D E
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Historical default rate 0.00693 0.00693 0.00693 0.1429

Mean MBFSR 3.03 3.06 2.81 3.58
Standard error, MBFSR 0.625 0.5876 0.877 0.5735
Default rate 0 0 0.046296 0.326316
Lower confidence
interval limit,
default rate
(95 percent) 0 0 0.0152 0.2602
Upper confidence
interval limit,
default rate
(95 percent) 0 0 0.1047 0.3979

Notes: This table reports the results of the mapping of the simulated rating system into
the MBFSR system by MBFSR grade. The estimated default probability using the
logit model is noted pD. As the number of observations by rating grade (simulated and
Moody’s) is low, we use exact confidence interval limits under the hypothesis of binomial
distribution of the proportions.

than they are in the sample used by Carey and Hrycay (2001).12 Another possible
explanation for our result is the time period under investigation, as the end of the
1990s was a period of financial distress in many emerging markets, affecting bank
quality and default risk.

Conclusion

This paper investigates the consistency between an agency rating—the Moody’s

BFSR—with the results of a bank default model in emerging market economies.
The MBFSR represents Moody’s opinion regarding a bank’s financial strength. To
carry out the investigation, we apply a scoring and mapping methodology, following
Carey and Hrycay (2001), to a sample of almost 500 rated banks from emerging
market economies in Eastern Europe, Southeast Asia, and Latin America over the
period 1998–2002.
Quantifying Moody’s rating grades using a scoring method shows a satisfactory
consistency between the MBFSR and the observed default risk in the sample. The
mapping method results suggest a tendency for default risk information to aggregate
into intermediate–low quality rating grades.
 20 EMERGING MARKETS FINANCE AND TRADE

Apart from examining other rating determinants, as well as the stability of

the effect of the time horizon on ratings through the cycle, further research could
investigate the consistency of other agency ratings, such as Fitch or Standard and
Poor’s ratings, with bank default risk.
Finally, it might be interesting to confront risk measures computed from an
agency rating and from a structural model of default to examine the usefulness of
a rating as a short-term indicator of risk.

Notes
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1. In the banking industry, the consistency feature is even more crucial because of banks’
assets opacity (Morgan 2002).
2. See Kräussl (2005) for an example.
3. The literature dealing with internal ratings is not discussed in this paper. We invite
the reader to consult contributions by Machauer and Weber (1998) and Treacy and Carey
(2000), which focus on this topic.
4. For example, ratings transitions matrices are important inputs for credit derivatives
pricing.
5. However, this stability might be inconvenient when the rating integrates new informa-
tion too slowly regarding a counterpart’s situation, which then harms the rating informational
capacity (Löffler 2005). See also Posch (2006) for additional evidence on the stickiness of
rating changes.
6. See Maddala (1983) for a detailed description of logit models.
7. We do not have any banks with A ratings, as these are very rare in emerging mar-
kets.
8. See also Staikouras (2005) for recent empirical evidence on financial crisis scoring
models for emerging market economies.
9. The number of observations by simulated rating grade is, in increasing grade order:
116, 64, 108, and 109.
10. The present study aims not to investigate the effect of a time horizon on scoring
model performances. For such an investigation, see Altman and Rijken (2004), who show
that agency ratings are rather stable through business cycles, validating the through-the-cycle
hypothesis. The prudent transition policy is the main explanation for this result.
11. Source: Credit Risk Calculator, Moody’s Investor Services. We use the transition
matrix excluding withdrawn ratings, with the following correspondence between the Moody’s
credit ratings and MBFSR (the speculative grade begins at the Baa rating for Moody’s):
Aaa = A, Aa = B, A = C, Baa-B = D, Caa-C = E. For the DEFAULT category, we use the
weighted mean of the transition rates. The summary of the Moody’s transition matrix is
given in Appendix Table A1.
12. The importance of banks rated D in our sample could affect this result, especially
in Latin America and Eastern Europe, where such banks account for 55.35 percent and 68
percent of the sample, respectively.

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Table A1

Summary of Moody’s Rating One-Year Transition Matrix, 1998–2002 (in percent)

Rating to
Ratings Aaa Aa A Baa Ba B Caa-C Default

Aaa 100.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Aa 0.00 97.14 2.86 0.00 0.00 0.00 0.00 0.00
A 0.00 1.67 96.67 1.67 0.00 0.00 0.00 0.00
Baa 0.00 0.00 15.38 81.40 2.35 0.00 0.00 0.87
Ba 0.00 0.00 0.00 14.24 82.80 2.46 0.50 0.00
B 0.00 0.00 0.00 0.00 14.67 79.87 4.24 1.21
Caa-C 0.00 0.00 0.00 0.00 0.00 15.00 70.71 14.29

Notes: This table reports the summary of the Moody’s rating one-year transition matrix for the countries in the sample over the period
1998–2002. Letter migration-rate summary excluding withdrawn ratings. Average one-year rating migration rates for December 31, 1998, to
December 31, 2002.
JULY–AUGUST 2007
23