77385

              the world bank economic review, vol. 16, no. 2 149–150


               Financial Crises, Credit Ratings, and Bank Failures

                                 An Introduction

                                   Carmen M. Reinhart




Financial crises of every variety rocked emerging markets in the second half of
the 1990s. Nearly every region experienced currency crashes, banking crises were
both numerous and severe, and a few countries, facing extreme duress, defaulted
on their sovereign debt. Not surprisingly, then, there is considerable interest in
policy and academic circles and within the investment community in gaining a
better understanding of financial and economic distress.
    An aspect that has received particular attention in the growing empirical lit-
erature on financial crises is crisis prediction or, more broadly, assessment of
imminent downside risks—for banks, currency, or sovereign debt. Much of this
literature focuses on selecting the “right� set of economic and occasionally po-
litical fundamentals. Rating agencies, responsible for monitoring credit risks,
came under considerable scrutiny following their lackluster performance in anti-
cipating the Mexican peso crisis (which nearly resulted in default) and the Asian
crises of 1997–98.
    The impact of changes in sovereign credit ratings on financial markets also
became a matter for debate, with some evidence that credit rating agencies could
be fueling a boom-bust cycle in international capital markets. Central banks
across the globe and multilateral lending institutions in particular became pain-
fully aware of the pressing need to develop and implement more robust ways of
“stress testing� financial systems, to ensure adequate capital requirements and
provisioning and limit the risk of bank failure.
    Three articles in this issue address various aspects of these topics—in particu-
lar, the behavior and impact of sovereign credit ratings and the development of
a portfolio model for testing the vulnerability of banks. Two of the articles ad-
dress the usefulness and impact of sovereign credit ratings. Reinhart evaluates
the performance of credit ratings in anticipating currency crises and defaults,
finding that ratings systematically fail to anticipate currency crises but do some-
what better in anticipating defaults. However, downgrades in credit ratings usu-
ally follow currency crises, suggesting both that currency instability increases
the risk of default and that credit ratings tend to be procyclical. Using a very

    Carmen M. Reinhart is a professor of economics with the University of Maryland, on leave at the
International Monetary Fund. Her e-mail address is creinhart@imf.org.

   © 2002 The International Bank for Reconstruction and Development /    THE WORLD BANK




                                               149
150    the world bank economic review, vol. 16, no. 2


different sample, data frequency, and analytical approach from Reinhart,
Kaminsky, and Schmukler also find evidence of procyclicality in sovereign credit
ratings. They show that credit upgrades usually take place during market rallies
and downgrades during bond and equity market slumps.
   In the third article, Balzarotti, Falkenheim, and Powell focus on bank defaults
rather than sovereign defaults, exploring how capital and provisioning measures
can limit bank failures. Their approach stresses a portfolio-based model for esti-
mating the potential losses of banks under a variety of adverse but plausible
scenarios. An important implication of their study is that for the many emerging
markets that have developed public credit registries, the information collected
by these agencies can be used to develop better measures of banks’ credit risks.