The Procyclical Role of Rating Agencies: Evidence from the East Asian Crisis

TLDR

Rating agencies failed to predict the East Asian crisis and subsequently adopted overly conservative assessments. The study proposes an endogenous explanation for why rating agencies become overly conservative after making clear prediction errors during the East Asian crisis. The mechanism posits that agencies increase conservatism to recover from reputational damage caused by prior prediction errors. The findings show that rating agencies exacerbated the East Asian crisis by issuing unjustified downgrades, raising borrowing costs, draining capital, and amplifying the downturn.

Abstract

We demonstrate that credit rating agencies aggravated the East Asian crisis. In fact, having failed to predict the emergence of the crisis, rating agencies became excessively conservative. They downgraded East Asian crisis countries more than the worsening in these countries' economic fundamentals would justify. This unduly exacerbated, for these countries, the cost of borrowing abroad and caused the supply of international capital to them to evaporate. In turn, lower than deserved ratings contributed – at least for some time – to amplify the East Asian crisis. Although this goes beyond the scope of our paper, we also propose an endogenous rationale for rating agencies to become excessively conservative after having made blatant errors in predicting the East Asian crisis. Specifically, rating agencies would have an incentive to become more conservative, so as to recover from the damage these errors caused to them and to rebuild their own reputation.