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The rating agencies' and bank supervisors' records of prompt identification of banking problems in emerging markets has not been satisfactory. This paper suggests that such deficiencies could be explained by the use of financial indicators that, while appropriate for industrial countries, do not work in emerging markets. Among the conclusions, this paper shows that the most commonly used indicator of banking problems in industrial countries, the capital-to-asset ratio, has performed poorly as an indicator of banking problems in Latin America and East Asia. This is because of (a) severe deficiencies in the accounting and regulatory framework and (b) lack of liquid markets for bank shares, subordinated debt and other bank liabilities and assets needed to validate the "real" worth of a bank as opposed to its accounting value. In spite of these problems, an appropriate set of indicators for banking problems in emerging markets can be constructed. But such a system should be based not on the quality of banks loans or on levels of capitalization, but on the general principle that good indicators of banking problems are those that reveal the "true" riskiness of individual banks because they are based on markets that work rather than just relying on accounting figures. Of the alternative indicators proposed in this paper, interest rate paid on deposits and interest rate spreads have proven to be strong performers. In contrast to the interpretation of banks' spreads in industrial countries, low spreads in emerging markets have not always indicated an increased in bank efficiency. Instead, low spreads have often reflected the high-risk taking behavior of weak banks. A difficulty that rating agencies may encounter in considering the suggested approach in this paper is that the methodology implies that the appropriate indicators of banks' performance evolve over time as markets develop and that, given large differences among emerging markets, a single set of indicators will not "fit all". The basic principle that "indicators work where markets work" is the leading guide to the selection of effective indicators. In spite of these considerations, we believe that in facing the trade-off between "uniformity across countries" and "effective indicators", rating agencies would be better off by focusing on the latter.

Rating Banks In Emerging Markets: What Credit Rating Agencies Should Learn From Financial Indicators