This paper examines the quality of credit ratings
assigned to banks in Europe and the United States by the
three largest rating agencies over the past two decades.
We interpret credit ratings as relative assessments of
creditworthiness, and define a new ordinal metric of
rating error based on banks’ expected default
frequencies. Our results suggest that rating agencies
assign more positive ratings to large banks and to those
institutions more likely to provide the rating agency
with additional securities rating business (as indicated
by private structured credit origination activity).
These competitive distortions are economically
significant and help perpetuate the existence of
‘too-big-to-fail’ banks. We also show that, overall,
differential risk weights recommended by the Basel
accords for investment grade banks bear no significant
relationship to empirical default probabilities.