Discussion Paper No. 656

THE DEMISE OF
BANK-CENTERED ECONOMY AND
INCREASING ROLESOF CREDIT RATING IN JAPANNobuyoshi Yamori
andYoshihiro Asai

March 2006

The Institute of Social and Economic Research
Osaka University
6-1 Mihogaoka, Ibaraki, Osaka 567-0047, Japan

March 2006

The Demise of Bank-centered Economy and Increasing Roles of Credit
Ratings in Japan

Nobuyoshi Yamori
Graduate School of Economics, Nagoya University
Nagoya 464-8601 Japan
Institute of Social and Economic Research, Osaka University
Osaka 560-0047 Japan(tel.) (+81)52-789-4935, (fax) (+81)52-789-4924(e-mail) yamori@soec.nagoya-u.ac.jp
And
Yoshihiro Asai
Graduate School of Economics, Nagoya University[Abstract]
After the burst of the bubble economy, Japanese economy has been changed drastically.
Traditionally, Japanese economy was characterized as a bank-centered economy, but thebanking system did not function well in the 1990’s. Responding to banking problems, theJapanese government initiated the Financial Big Bang in 1996 to strength the capability ofcapital markets. Also, accounting and disclosure rules have been revised to make more credible
and wider information available to market participants. If other things be constant, more
extensive and timely disclosure should result in more accurate evaluation of firm’s risks.
However, there is a lack of research that investigates how effective current disclosure is inevaluating corporate risks. This lack of research is mainly because there are not appropriate data
sets and methodology to be used for empirical tests. Fortunately, Morgan (2002) proposed avery useful method. That is, he used the disagreement between credit rating companies (i.e.,
Moody’s and Standard and Poor’s) over new issued bonds to measure the difficulty inevaluating firms’ risks. In this paper, we follow Morgan (2002) and investigate whether credit
rating companies likely agreed on the evaluation on Japanese firms’ risks after the financial andaccounting Big Bang. If there are still large disagreements among credit rating companies, thisfact suggests that the current disclosure is not enough for outsiders to evaluate firms, or that
there is an inherent limitation of disclosure usage. Also, we are interested in what sectors credit
rating companies more often disagree on. Contrary to Morgan (2002), which pointed out that
financial industries, such as banks and insurance companies, are difficult to evaluate, we failed
to find that disagreements among credit rating companies over banks and insurance companies
are larger than disagreements over other industries. However, consistent with Morgan (2002),
we found that public utilities industry is easy to evaluate.
This paper is organized as follows. In Section 2, we discuss the current Japanese economic
situation and explain the accounting and disclosure reform. In Section 3, we explain data andmethodology that are used in this paper. In Section 4, empirical results are provided. Section 5
concludes this paper.

JEL Classification Code: G10, G21
Key words: Credit ratings; Japanese finance; Credit raters; Bank.

The Demise of Bank-centered Economy and Increasing Roles of Credit
Ratings in Japan

1. Introduction
After the burst of the bubble economy, Japanese economy has been changed drastically.
Traditionally, Japanese economy was characterized as a bank-centered economy, and capital
markets played only a marginal role. Unfortunately, many banks that took too much risk
exposures in the late 1980’s faced financial difficulties in the 1990’s, and some banks actuallywent into bankruptcy. Failures of Hokkaido Takushoku Bank in 1997 and Long-Term Credit
Bank of Japan in 1998 were splendid examples. As these banks consisted of the core ofJapanese financial society, many firms that heavily financially depended on these failed banks
experienced serious financial problems (Yamori and Murakami, 1999). Furthermore, even banks
that survived were seriously lack of capital and reluctant to extend loans to small and medium
size enterprises.
As the banking system did not function well, the government concluded that it was necessary
to strength the market-based finance, and started to deregulate securities markets and modernizebanking regulations in 1996. This extensive reform initiative is called “Financial Big Bang.”Also, accounting and disclosure rules have been revised to make more credible and wider
information available to market participants because appropriate disclosure is essential for themarket-based finance. Now, Japanese observers agree that the disclosure standard of Japanesefirms is far better than before.
If other things be constant, more extensive and timely disclosure should result in more accurate
evaluation of firm’s risks. However, it may be still very difficult to monitor firms’ risks fromoutside due to the following reasons. First, disclosure regulation may be useless if it does not
require firms to disclose really important information. Second, nowadays firms operate more
complex businesses whose risks are hard to evaluate. Typical examples are found in banking
businesses. Traditionally, banks operated very simple business; raising funds as deposits andlending them to corporations. Now, banks operate internationally and engage in various
businesses, such as investment banking and derivative transactions. Therefore, the issue of
whether risk evaluation is easier than before is an empirical research question.
Although investigating how effective current disclosure is in evaluating corporate risks isrelevant to current regulation, there are only a few papers investigating this issue. This lack of
research is mainly because there are not appropriate data sets and methodology to be used for
empirical tests. Fortunately, Morgan (2002) proposed a very useful method. That is, he used the1disagreement between credit rating companies (i.e., Moody’s and Standard and Poor’s) over
new issued bonds to measure the difficulty in evaluating firms’ risks. In this paper, we follow
Morgan (2002) and investigate whether credit rating firms agree on the evaluation on Japanesefirms’ risks more often than before. If there are still large disagreements among credit ratingcompanies, this suggests that the current disclosure is not enough for outsiders to evaluate firms’
creditworthiness. Also, we are interested in what sectors credit ratings companies more often
disagree on in terms of risk evaluation. Morgan (2002) pointed out, financial industries, such as
banks and insurance companies, are difficult to evaluate. We investigate whether his findings
are confirmed by using Japanese data.
This paper is organized as follows. In Section 2, we discuss the current Japanese economic
situation and explain why Japan aimed to shift from bank-based finance to market-based finance.
Also, we briefly explain the accounting and disclosure reform. In Section 3, we explain data andmethodology that are used in this paper. In Section 4, empirical results are provided. Section 5
concludes this paper.

2. The Changing Japanese Economy
2.1 The Lost Decade
The Japanese economy, whose nominal GDP for 2002 was 499 trillion yen, is the second largest
economy in the world. Although Japan had experienced remarkable economic growth after theSecond World War, Japan suffered from a stagnant economy in the 1990’s. The 1990's are often
called 'the Lost Decade’ because of low nominal GDP growth rates, prolonged deflation, andhuge declines of asset prices in that decade. The GDP growth rate was very low or evennegative in the late 1990’s. Average annual nominal GDP growth rates were 6.4% from 1985 to
1990, 2.2% from 1990 to 1995, 0.4% from 1995 to 2000, and -1.6% from 2000 to 2002. Low
economic growth has increased unemployment rates significantly. Although Japan was known
as a country with low unemployment rates (e.g. 2.1% in 1990), recent unemployment rates areabove 5 percent (e.g., 5.3% in 2003).
The second feature of the stagnant economy in the 1990’s is the prolonged deflation. GDP
deflator has been negative since 1994. To fight against deflation, the Bank of Japan reduced
interest rates to almost zero. Overnight interbank loan interest rates (i.e., call rates) have been
about 0.001% since 2001. Long-term interest rates are also very low. For example, the yield of
newly issued government bonds (10 years maturity) was below 1% in 2002.
The third characteristic is the sharp decline in asset prices in the 1990's, which is often called
the burst of the bubble. Land prices have continued to decline since 1992. According to
Officially Published Land Prices (Chika Koji) issued by the Ministry of Land, Infrastructure,2

and Transport, the average land prices for 2002 were only 55 percent of those for 1991. Also,
stock prices drastically declined in the 1990's. For example, the Nikkei 225 Average, the mostpopular stock price index, recorded its highest value of 38,915 at the end of 1989, while itdeclined to below 7,900 in April 2003.
During the Lost Decade, Japanese banks met unprecedented difficulties. Traditionally, realestates were often used as collaterals for bank loans. According to the data on bank loans bycollaterals released by the Bank of Japan, Real Estate and Floating Mortgages are often used asloan collaterals. Namely, as shown in Figure 1, the ratio of loan with Real Estates and Floating
Mortgages as collateral to total bank loans peaked in 1992 (i.e., 28.4%). Furthermore, in the late1980’s (i.e., the bubble period), Japanese banks were eager to provide funds to real estatescompanies. At that time, Japanese banks felt that they were well secured because of so-called“Land Myth,” which means that land values never decline. Banks’ high dependency on land
values functioned very well so long as land prices continued to rise.
Owing to the deflation in the 1990’s, borrowers suffered from the appreciation of real values ofdebts. As real estate companies had huge land in the portfolio and borrowed huge money frombanks, they were vulnerable to land price declines. Unfortunately, the deflationary effect was
not limited to the real estate industry. With the prolonged deflation, the number of firms thatwent into bankruptcy rose to an unprecedented level (e.g. the number of corporate bankruptcies
was 19,164 for 2001, three times larger than that for 1990). Japanese financial institutions
suffered from huge bad loan problems1. Figure 2 shows that bad loans remained large in spitethat Japanese banks incurred over five trillion yen losses every year by writing off or selling off
problematic loans. Although recently bad loans tend to decline, Japanese banks still held 36.2
trillion yen in bad loans at the end of Fiscal 2003 (i.e., March 31, 2004)2.
The bad loan problems seriously damaged banks and other financial institutions, and some ofthem went into bankruptcy in the late 1990’s. (See Table 1). These frequent bank failures were
all the more shocking because there was no bank failure for fifty years until 1995. Moreseriously, even solvent banks were reluctant to extend loans to riskier borrowers, such as small
size enterprises. After the failure of Hokkaido Takushoku Bank in November 1997, severe credit
crunches were observed nation-widely. As shown in Figure 3, bank loans amounted to 493
trillion yen at the end of 1997. Then, bank loans have declined to 413 trillion yen at the end of
2003.
1

When a borrower fails to repay loans, a bank forecloses collaterals and sells them. Japanesebanks usually ask borrowers to pledge as collateral that is more worth than the loan amount.
Unfortunately, the price of land declined very much, banks often found that collateral values
were smaller than loan amounts in the late 1990’s. Eventually, although bank sold the collaterals,bank could not cover the default losses.
2
There are several definitions of bad loans in Japan. The figures that we used in this chapter are
those of risk monitored assets (Risuku-Kanri-Saiken in Japanese).
3

Figure 1. The Ratio of Loan with Real Estate as Collateral

30.0%
28.0%
26.0%

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

24.0%
22.0%
20.0%

(Source) Bank of Japan.
Figure 2. Bad Loans and Loan Losses of Japanese Banks
45

loan losses
bad loans

40（triilio n yen ）

35
30
25
20
15
10
5
0
1992

1994

1996

1998

2000

2002

(Note) Figures until 1994 were based on only major banks, and figures since 1995 were basedon all domestic banks.
(Source) Financial Services Agency.

4Figure 3. Loans and Discounts of Domestically Licensed Banks (trillion yen)

600
500
400
300
200
100
0
1984

86

88

90

92

94

96

98 2000

02(source) Bank of Japan.
Table 1. Major Failures of Japanese Banks, Insurance and Securities Firms: 1995-1999
Date

Financial Institution

7-31-95
8-30-95
8-31-95
12-7-95
4-1-96
11-21-96
4-25-97
5-14-97
5-14-97
10-14-97
11-04-97
11-17-97
11-25-97
11-25-97
3-17-98

Cosmo Credit Cooperative
Kizu Credit Cooperative
Hyogo Bank
Osaka Credit Cooperative
Taiheiyo Bank
Hanwa Bank
Nissan Life Insurance
Tanabe Credit Cooperative
Chogin Osaka Credit Cooperative
Kyoto Kyoei Bank
Sanyo Securities
Hokkaido Takushoku Bank
Yamaichi Securities
Tokuyou City Bank
Wakayamaken Shoko Credit
Cooperative
Midori Bank
Long-term Credit Bank of Japan
Nippon Credit Bank
Kokumin Bank
Koufuku Bank
Tohou Life InsuranceTokyo-Sowa Bank
Namihaya Bank
Niigata-Chuou Bank

5-15-98
10-23-98
12-14-98
4-12-99
5-24-99
6-7-99
6-14-99
8-9-9910-4-99(Source) Spiegel and Yamori (2004a).

5

Deposit Insurance Expense(100 million yen)
1,250
10,340
4,730
2,526
1,170
2,960
NA
1,081
3,159
1,019
NA
33,726
NA
2,888
2,193
10,56040,37832,365
2,180
6,647
NA
8,868
8,431
4,838

2.2 Decreasing Importance of Banks’ Roles in Japanese Economy
Japanese banks have played very important roles in Japanese financial system, and a vast
amount of studies has been devoted to clarify their roles. It is well-known that Japanese banks
keep close long-term relationship with corporate customers. This is called “main-bank”
relationship. A main-bank is generally a bank; (1) that provides the largest amount of loans to
the firm, and (2) that is a major shareholder of the firm. Furthermore, it is often observed that
persons who retired from the main-bank are employed as board members of customer firms.
Several studies demonstrate that as the “main-bank” relationship reduces the costs induced byasymmetric information, it has economic rationale. As the asymmetric information problem isseverer when firms face financial distress, the values of main-bank relationship may be easily
observed regarding financially distressed firms. For example, Hoshi, Kashyap, and Sharfstein(1990) investigated investment of firms in financial distress and found that firms that belonged
to Keiretsu invested more than independent firms. Gibson (1995, 1997), Yamori and Murakami(1999), Kang and Stulz (2000) and Brewer, et al. (2003) showed that weak main banks had
negative effects on corporate customers. Kaplan and Minton (1994) showed that bankers werelikely to be appointed as firm’ directors when their customer firms were in financial distress. To
summarize, previous studies agree that Japanese banks have played active corporate governanceroles.
However, the importance of the role of banks has been decreasing as financial deregulation
advances since the late 1970’s. Big firms raise more funds through financial markets. For
example, amount of new corporate straight bonds issue was only one trillion yen in 1988, while
it was 12 trillion yen in 2003. (See Figure 3). As a result, banks begun to lose their priority infirm information, and their customer pool begun to deteriorate in the late 1980’s. Japanesebanks had to find new customers and started to increase loans to real estate firms. Hoshi and
Kashyap (2001) regarded this trend as a major cause of bad loans problems.
The financial Big Bang accelerated the declines of bank roles. First, Japanese banks used tohold huge amounts of stocks of customer firms, but were forced to sell them due to their fragile
capital positions. Domestically licensed banks held stocks of 47 trillion yen in their banking
account at the end of 1997, while they halved stock holdings to 24 trillion yen at the end of
2003. Second, foreign investors increase investment in Japanese firms. For example, foreign
investors had 8.1% of outstanding stocks of all listed companies at the end of March 1995,
while they had 21.8% on March 31, 2004. Unlike traditional friendly shareholders, foreign
shareholders are active to govern management. Under foreign investors’ pressure, Japanesemanagers have to consider their stockholders’ profits first. Third, as bank capital position
weakens, it is very hard for banks to assist financially distress firms. That is, main bank can not

6execute the implicit insurance contract with customer firms.
In sum, the government advances the deregulation of capital markets to harmonize Japanese
capital markets with international markets3. Currently, the usability of Japanese capital markets
is improved. Although banks are still important in screening and monitoring small andmedium-sized enterprises, capital markets are now expected to play important roles regarding atleast large companies finance and corporate governance.
Figure 4. New Issues of Corporate Straight Bond (trillion yen)

12
10
8
6
4
2
0
1988 90

92

94

96

98 2000 02(Source) Japan Securities Dealers Associations.

2.3 Accounting Reform; Kaikei Big Bang
It is often said that as banks can observe firm’s daily transactions through its checking accounts,
banks have a lot of private information to assess customer’s risks. In the bank-centered economy,
as firms borrowed necessary money from banks, they did not take care of conveying their true
financial conditions to capital market participants. Therefore, it was natural that Japanese firms
were reluctant to disclose their financial condition. In contrast, the quality of the disclosed
financial reports is crucial in the market economy. Market participants evaluate firm’s
creditworthiness based on disclosed documents, such as B/S and P/L. Therefore, disclosure andaccounting reform conducted since the late 1990’s were badly necessary to help market
participants, including credit rating companies, to evaluate the creditworthiness of Japanesefirms.
Although the government has conducted wide range disclosure reforms, we explain someexamples. First, Tokyo Stock Exchange requires companies listed in its Mothers Section (a3Of course, Japanese capital markets are different from U.S in several ways. For example, Kang,
et al. (1995) and Kang and Stulz (1996) fund that Japanese managers decide to issue shares andoffshore dollar-denominated convertible and warrant bond based on different considerations
from American managers.
7

special section for venture firms) to disclose quarterly financial reports since 1999 and all othercompanies listed in other sections since 2004, while Japanese listed companies were required todisclose biannual reports before. A second example is bank disclosure on bad loans. Banks did
not disclose their bad loans, and depositors were not interested in such figures because they
believed that their deposits were protected by Ministry of Finance. However, as bank failuresfrequently occurred, depositors wanted to evaluate bank solvency and demanded information on
bad loans. Responding to such demand, the government required banks to disclose these figures.
(See Table 3).
In Japan, the accounting reform is often called “Kaikei Big Bang.” The basic purpose of the
Big Bang is to harmonize Japanese accounting rule with the International Accounting Standard(IAS). Important steps includes the introductions of consolidated accounting and statement ofcash flow since March 2000, the introduction of mark-to-market evaluation of financial
products and accounting standard of retirement benefit since March 2001, and the introductionof mark-to-market evaluation of cross-holding shares since March 2002.
Of course, some observers criticize that important information that affects market evaluation of
the firm is not disclosed yet. For example, although current values of the “Other Securities” aredisclosed, what kinds of securities consist of them is not disclosed. So, market observers do notknow the maturity and denomination of “Other Securities.” If substantial parts of “Other
Securities” are foreign-currency denominated bonds, then investors should consider exchange
rate risks. Furthermore, development of financial markets enables firms to change their risk
exposures by reshuffling their balance sheet contents easily4.

4

Morgan and Stiroh (2001) found that capital markets negatively evaluate banks with larger
trading account and commercial loans. Flannery et al. (2004) also found that the bid-ask spreadof bank stocks is correlated with components of bank portfolios.
8Table 3. “Bad-loan” Disclosure Requirements among Japanese Financial Institutionsa

Large Banks(City,

BAD1

BAD2

BAD3

BAD4

March 1993

March 1993

March 1996b

September 1996cMarch 1993
March 1993

March 1996
March 1997dMarch 1997dMarch 1997dMarch 1997
March 1997

March 1996e

March 1998

March 1998

March 1998

long-term
credit,and trustbanks)

Regional Banks
Second Regional
Banks
Shinkin Banks
Notes:

a. This table is based on financial statement disclosure requirements. The total amount of bad loan that theentire deposit-taking financial institutions held has been disclosed since September 1995.
b. Voluntary disclosure has existed since September 1995. However, the figures were not included in theofficial financial statements for that year.
c. The figures have been voluntarily disclosed in annual report since March 1996.
d. The disclosure for March 1996 was voluntary and became required after March 1997. However, allbanks actually voluntarily disclosed their figures in March 1996.
e. The National Association of Shinkin Banks recommended disclosure by Shinkin banks with deposits
exceeding 100 billion yen. However, compliance was not universal.

(Source) Spiegel and Yamori (2004b).

2.4 Credit Rating Companies in Japanese Financial Markets
Credit rating companies are important players in developed financial markets. They evaluate thecreditworthiness of bond issuers, based on public information and sometimes on private
information that is obtained through interviewing managers. As the evaluation of credit ratingcompanies over bonds are made public, market participants can use the credit grades to judge
whether the bond is properly priced. In the developed financial markets, the bond should bepriced based on its risks. Of course, as shown in Figure 5, companies with higher credit grade
obtain cheaper funds in recent Japanese market.
Although credit rating companies have more than one century experience in the United States,
they have shorter history in Japan. As Japanese companies borrowed from banks and did notissue substantial amount of bonds, there were no needs for credit rating companies for a longtime. Credit rating companies are necessary only when many firms consider issuing bonds. At
first, when Japanese companies issued foreign bonds, they obtained credit grade from foreign

9credit rating companies. Then, due to the development of domestic bond markets, domestic
credit rating companies were established, and foreign credit rating companies started theiroperation in Japan.
Now, there are four major credit rating companies in Japan5. Two are Japanese companies, andremaining two are U.S. based companies. The leading domestic credit rating company is Rating
and Investment Information, Inc.(R&I). R&I succeeded Nihon Bond Research Institute (NBRI)
and Nihon Investors Services (NIS). The NBRI was established in 1979 by Nihon Keizai
Shinbun, and the NIS was established in 1985. In 1998, the NBRI and the NIS were merged into
R&I. In 2003, R&I covered approximately 600 domestic firms. Another Japanese credit ratingcompany is Japan Credit Rating Agency (JCR), which was established in 1985. In March 2004,
JCR assigned credit ratings to 590 domestic firms. JCR is active in providing the credit ratings
to financial, retail, and services sectors.
Although two U.S. based companies operate internationally and have more than one century
history, their operations in Japan started only in mid 1980’s. Moody’s Japan K.K. wasestablished in 1985 as a subsidiary of Moody’s Investors Service Inc. Now, Moody’s Japan(simply Moody’s below) covers about 300 Japanese firms. Standard & Poor’s (S&P) first assign
credit grades to a Japanese firm in 1975 and opened Tokyo branch in 1986. Now, 140 people
work for S&P in Tokyo and about 360 Japanese firms obtain credit grade from S&P.
The number of firms that these credit rating companies assign credit ratings is increasing.
According to Japan Credit Rating Agency, 916 firms and organizations had credit rating as ofMarch 20046. In the real business world, the influence of credit ratings was deeply recognized
during the Yamaichi and Hokkaido Takushoku crises. It is commonly believed that thesefinancial institutions could not obtain necessary funds from the short-term markets because of
the rapid downgrade of their credit ratings and were forced to go into bankruptcy. For example,
Yamaichi, one of four Japanese big securities companies, was downgraded several times before
the failure. Concretely speaking, the NBRI downgraded Yamaichi Securities from A+ to A in
February 1997, which was only nine month before the Yamaichi failure (November 24). The
NBRI announced that it would downgrade Yamaichi further on July 30, and actually
downgraded it from A to BBB on November 20. Moody’s first announced that it would
downgrade Yamaichi from BBB+ on November 6, and then it downgraded Yamaichi from
BBB+ to BB+ on November 21, just three days before the bankruptcy. S&P was moreaggressive in downgrading Yamaichi. S&P first announced that it would downgrade Yamaichi
from BBB+ on April 17, and actually downgraded it from BBB+ to BBB on June 5. On
5The Financial Services Agency declares five credit rating companies (i.e., Moody’s, S&P, R&I,
JCR, and Fitch ratings) as “Authorized Credit Rating Companies.”
6
Recently, not only listed companies, but also government agencies, local governments, anduniversities request rating companies to assign the grades.
10November 17, S&P downgraded Yamaichi from BBB to BBB-, and on November 21,
announced that it would downgrade Yamaichi furthermore. Similar situation occurred regarding
Hokkaido Takushoku Bank.
There is another evidence to verify that credit ratings enhanced influence in the late 1990’s.
That is, we counted how many articles in Nihon Keizai Shinbun, the most popular businessnewspaper in Japan, used a word “credit ratings” ( Kakuzuke in Japanese). We found that 773
articles used Kakuzuke during 1980 to 1984, 2070 during 1985 to 1989, 5379 from 1990 to
1994, 8906 during 1995 to 1999, and 5019 during 2000 to 20047. The number of usage ofKakuzuke during the 1995-99 period is more than ten times larger than that during the 1980-84
period.
Above informal evidences were supported by Bremer and Pettway (2002), who examined thestock prices of Japanese banks that were subsequently downgraded by Moody's InvestorsServices during the 1986–1998 period. The paper found that the market imposed a significant
penalty before as well as at the time of downgrades by Moody's. This suggests that the ratingcompany created information that affected shareholders’ evaluation.

Figure 5. Market Interest Rates of Bonds by Credit Ratings

％

2
1.8
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0

AAA
A
BB
1

2

3

4

5
6
7
8
maturity (year)

910(Notes) Credit ratings are based on S&P’s. Interest rates and ratings are as of May 2004.
(Source) Japan Securities Dealers Association.

3. Methodology and Data
3.1 Methodology
7

Note that we include data only until September 22, 2004.
11

As mentioned above, the accounting reform has been advanced and credit rating companies
have played more and more important roles in Japanese economy. However, there is a criticalquestion whether credit rating companies appropriately rate the grade. When a credit ratingcompany downgrades Company A, Company A often claims that the downgrade is not justified
by the company’s true situation8. Therefore, it is interesting to investigate the ability of credit
rating companies. A standard method is to evaluate the ex-post default probability by credit
grade. But we have to wait for a long time to accumulate relevant information.
Therefore, we use another methodology that can be conducted with current data sets.
Concretely, we follow Morgan (2003), who focuses on disagreement between rating companies
over new issue bonds. The basic idea of Morgan (2002) is simple: if firm’s risk is harder toobserve, the raters in the business of judging risks should disagree more often over firm
creditworthiness. Similarly, we assume that the fact that credit rating companies likely agree on
the creditworthiness of a firm suggests that credit rating companies make more accurate
judgment. If there is one true solvency condition of Company A, the answer about its solvency
should be the same among credit rating companies. Both more information and higher ability ofcredit rating companies should lead to smaller gaps in evaluation among credit rating companies.
Unfortunately, we confess in advance that we can not separate the more-information hypothesis
from the higher-ability hypothesis. So, at this stage, we can only document how differently four
credit rating companies rate Japanese firms.
The methodology that Morgan (2003) used is as follows. First, he collected credit ratings by
Moody’s and S&P regarding newly issued bonds during 1983-1993. Second, he mapped theletter ratings of rating agencies, such as AAA, to a single numeric scale in the following manner.
As shown in Table 4, AAA (or Aaa) is assigned 1, AA+ (Aa1) is 2. So, better letter ratingscorrespond to lower numbers and vice versa. Third, he calculated basic statistics, such as
average scores and rank correlations in order to compare credit ratings assigned by S&P and
Moody’s. Finally, he found that the disagreement over banks and insurance companies are larger
than the disagreement over other industries.
We follow the Morgan’s methodology and examine the disagreements among four raters. Notethat two Japanese credit rating companies, R&I and JCR, use the same letter ratings as S&P.

8

For example, Moody’s downgraded Japanese life insurance companies on March 11, 2002.
Nihon Life Insurance, the largest insurance company in Japan, which was downgraded fromAa3 to A3, announced that as its solvency remained good, it could not understand this sudden
downgrade. (See Mainichi Shinbun, March 11, 2002).
12

Table 4. The Letter Ratings and Numeric Scale
Score
Moody’s
S&P
1
Aaa
AAA
2
Aa1
AA+
3
Aa2
AA
4
Aa3
AA5
A1
A+
6
A2
A
7
A3
A8
Baa1
BBB+
9
Baa2
BBB
10
Baa3
BBB11
Ba1
BB+
12
Ba2
BB
13
Ba3
BB14
B1
B+
15
B2
B
16
B3
B17
Caa1
CCC+
18
Caa2
CCC
19
Caa3
CCC-

3.2 Data Source
While Morgan (2003) used credit ratings of U.S. new issued bonds, it is hard to use those data
regarding Japan. First, unlike the United States, not so many Japanese companies issue bonds.
Particularly, financial institutions, including banks and non-bank finance companies had beenprohibited from issuing bonds until recent year. For example, Japanese banks were allowed toissue straight bond since 1999. So, new issue bonds data are only available regarding some
limited sectors9. Second, it is not so common that more than two credit ratings companies rate
new issued bonds in Japan. For example, R&I alone rated new straight bonds that were issued
by Sanwa Bank, a city bank, in 1999. Third, theoretically we expect that firms that could issue
straight bonds suffered from less asymmetric information problem. In other words, firms withlarger disagreement among credit rating companies were hard to issue bonds. Therefore, newissue sample might be biased toward concluding that the disagreements are small.

9

The numbers of new issues of straight bonds since 1998 are 764 for 1998, 694 for 1999, 411
for 2000, 354 for 2001, 282 for 2002, and 366 for 2003. Many firms issue several times.
13

Here, we use issuer ratings, which are often cited in Japan10. The issuer ratings are reported invarious sources, such as Nikkei Kaisha Joho and Kaisha Shikiho, both of which are quarterly
issued and are commonly used by Japanese investors. The problem to use the issuer ratings
exists due to the different timing of the revision. Credit rating companies regularly consider
whether current credit rating is appropriate. The difference in credit ratings may simply reflectthat a credit rating company revises the grade faster than others. This timing issue is minimized
if we use the Fall issue of Kaisha Joho. Accounting year of most Japanese firms are from April 1
to March 31. The Laws require that the authorized accounting data should be disclosed within
three months after the end of the accounting year. So, when the Fall issue is published, we canfairly expect that all rating companies consider new information that was released by July, andrevise the grade if necessary.
Here, we examine the disagreement of firms’ ratings by using the Fall issue of Nikkei Kaisha
Joho for years 1999, 2002 and 2004. These years are the exact period that the Japan’s Big Bang
has developed. We are interested in investigating credit ratings in the earlier period. However,both Kaisha Joho and Kaisha Shikiho did not include information on credit ratings before 1997.
This also suggests that credit ratings were not important before the financial crises. Fortunately,
all four credit rating companies kindly provided us the list of their rating grades around the endof August 1996. Therefore, we use these data for 1996. Furthermore, we cannot use the Fallissue of 2004 because our investigation was conducted in Summer 2004. Note that we use theSummer 2004 version for the 2004 investigation.
3.3 Data Description
As mentioned above, there are four major credit rating companies in Japan. The coverage offirms that four credit rating companies assigned credit rating varies. For our purpose, the firmsthat are rated by at least two credit rating companies do matter. We call them multi-rated
companies. Table 5 shows that the number of multi-rated firms increased from 1996 to 2004. In
10

The current credit ratings are available at the homepages of credit rating companies without
any charge, but the old data are not available on homepages.
Address

R&I

http://www.r-i.co.jp/

S&P

http://www.standardandpoors.com/japan/

JCR

http://www.jcr.co.jp/

Fitch

http://www.fitchratings.co.jp/

Moody’s

http://www.moodys.co.jp/

142004, more than 250 Japanese firms are multi-rated, and (although not shown in the table) 817
firms out of 3700 listed companies have a credit rating from at least one credit rating company.
This is consistent with our findings in Section 2.4 that credit ratings have played more and more
important roles in Japan.
Table 5 also shows average ratings of four credit rating companies. American raters assigned
more unfavorable grades to Japanese firms than Japanese raters. For example, there is 0.79
notch difference between S&P’s mean grade and JCR’s mean grade for 2004. However, thiscomparison may not be appropriate because each rater evaluated different companies. There are
only a few companies that have credit ratings from four rating companies for all four years. Oneof them is Japan Airlines (JAL). Figure 6 shows the changes of the credit ratings of JAL by four
credit rating companies. As of 1996, JCR rated JAL as AA, while S&P rated it as BBB+. Then,
all credit rating companies downgraded JAL by four to seven notches. There are two remarkablefeatures. First, the credit ratings of JAL are not converging among four rating companies. Large
disagreement remains. Second, although there are a few notch differences among credit ratings,
the relative evaluation is stable. That is, S&P’s rating is always the lowest and JCR’s rating isalways the highest among four. Another firm that had four credit grades is Mitsui-Sumitomo
Insurance. All four rating companies rated Mitsui-Sumitomo Insurance as AAA for 1996. (SeeFigure 7). Then the evaluation became various. For 2004, JCR still rated it as AAA, while
Moody’s and S&P rated it as AA- (Aa3).
As there are few firms that have credit grades from all four companies, it is impossible tocompare four credit rating companies at once. For example, if we use only observations
common to four rating companies, the sample for 1996 includes only seven firms. However,there are many companies that have credit grades from two credit rating companies11. In thispaper, we focus on firms that have grades from two rating companies and investigate
disagreement of grades over these firms.

11

It is interesting, but beyond the scope of this chapter, to consider so-called rating shopping.
Usually, firms ask credit rating companies to rate the grade and pay some fees for the rating.
However, credit rating companies sometimes announce the rating of firms without firms’
request. Furthermore, Moody’s does not separate requested credit ratings from non-requested
ratings. Therefore, it is technically difficult to analyze the rate shopping issue.
15

Table 5. The Number of Multi-rated Firms
1996

1999

2002

2004

NumberAverage

NumberAverage

NumberAverage

NumberAverage

R&I

271

5.89

472

7.25

418

7.14

316

7.07

Moody's

202

7.37

260

8.40

249

8.73

232

7.53

S&P

57

4.95

182

8.52

255

9.31

276

7.38

JCR

185

6.69

359

7.25

330

6.65

271

6.74

All four

7

63

96

79

(Notes) Number = number of firms that the rater assigned the grade
Average = mean of the credit ratings for all firms that the rater assigned the grade

Figure 6. Credit Ratings of Japan Airlines (JAL)

14
12
10
8
6
4
2
0

R&I
Moody's
S&P
JCR

1996

1999

2002

2004

(Note) JAL was merged with Japan Air System (JAS) in 2002.
Figure 7. Credit Ratings of Mitsui Sumitomo Insurance Co.

5
4

R&I
Moody's
S&P
JCR

3
2
1
0
1996

1999

2002

2004

(Note) For 1996 and 1999, we used Mitsui Insurance, which was merged with Sumitomo
Insurance to Mitsui-Sumitomo Insurance in 2001.

16

4. Results and Interpretation
4.1 Whole Industries
In this sub-section, we use all firms to measure the size of disagreement among ratingcompanies. As every rating company rates different firms, we perform one by one comparison(e.g., R&I vs. Moody’s). Table 6 shows the results of comparison between two ratingcompanies12. Table 6 indicates average score of ratings for each rating company (numericalnumber), difference between them and their t-statistics.
First, we compare R&I and Moody’s. In 1996, these two credit rating companies commonly
rated 149 firms. The average rate of R&I was 4.50 (i.e., between AA- and A+) and that ofMoody’s was 7.28 (i.e., between A3 and Baa1). As shown in the same table, the difference inthe mean is statistically significant. As the larger number means lower credit rating in ourscoring rule, Moody’s evaluated Japanese firms more negatively than R&I did. Results for 1999,
2002, and 2004 are similar to that for 1996. Some readers may remark that the difference for2004 is the smallest. There are two possibilities. First, the evaluation of firms’ creditworthinessby R&I and Moody’s are converging. Second, the use of Summer 2004 issue of Kaisha Joho
may affect the results. Therefore, we should be cautious about drawing a final conclusion basedon results for 2004.
Table 6(ii) considers disagreement between Moody’s and S&P. The average rate of Moody’s
was 4.96 and that of S&P was 5.20 for 1996 13 . For all four years, S&P assigned more
unfavorable grades to Japanese firms than Moody’s. Except 1996, the differences are
statistically significant. Finally, between R&I and JCR, R&I assigned more unfavorable grades
to Japanese firms than JCR.
Table 6 shows that domestic rating companies tend to evaluate Japanese firms’
creditworthiness more highly than foreign rating companies. Although this tendency is aninteresting research topic, this paper does not consider this issue. What is important for thispaper is the fact that there remains large disagreement among credit rating companies overJapanese firms’ creditworthiness.

12

As there are four companies, there are six combinations. Here, we display three representative
results to save the space.
13
Note that the Moody’s average value in Table 6(i) is 7.28 and that in Table 6(ii) is 4.96. Thisdifference is caused by the different sample firms.
17

Table 6. Disagreement between Two Credit Rating Companies(i) R&I and Moody’s
Number

R&I

Moody'sdifferences t-value

1996

149

4.50

7.28

-2.79

-22.9

1999

227

5.71

8.39

-2.68

-28.6

2002

220

6.27

8.69

-2.42

-29.2

2004

171

6.84

7.54

-0.70

-3.3

(ii) Moody’s and S&P
NumberMoody's

S&P

differences t-value

1996

50

4.96

5.20

-0.24

-1.3

1999

157

7.83

8.38

-0.55

-4.5

2002

188

8.54

9.27

-0.73

-6.9

2004

167

6.94

7.38

-0.44

-2.4

(iii) R&I and JCR
NumberR&I

JCR

differences t-value

1996

154

6.91

6.83

0.08

0.8

1999

336

8.02

7.35

0.66

13.2

2002

298

7.47

6.74

0.73

16.5

2004

211

7.20

6.64

0.56

3.4

4.2 Correlation Analysis
The above results suggest that the absolute level of the credit ratings is different among ratingcompanies. However, if the relative evaluation is similar, the absolute difference may not be
crucial. For example, there are three companies, X, Y, and Z. A rating company rated X as AAA,
B as AA, and C as A, while another rating companies rated X as AA, Y as A, and Z as BBB. In
the sense that they ranked X is the best, Y is middle, and Z is the lowest, the relative
creditworthiness evaluation is the same. Here, similarity is measured according to values ofcorrelation coefficients between scores assigned by two rating companies. Namely, we examine
simple correlation and rank correlation among credit rating scores14.
Table 7 shows that the coefficients of correlation tend to increase in recent year except 2004,
suggesting that relative evaluation converges in recent years. The irregular results for 2004 may
14Here, we used Spearman’s Ro to show rank correlation.
18

be due to the fact that we used the Nikkei Kaisha Joho 2004 Summer issue, not the Fall issue
because of the availability when we conducted this research. That is, we suspect that there aresome time gaps in revising the grades based on newly released financial accounting reports
among rating companies, and that the observed increase of disagreement for 2004 may be atleast partially due to asynchronous changes in rating over time. Therefore, at this stage,
although we believe that the relative evaluation of credit rating companies likely converges, we
can not draw a definitive final conclusion.

19

Table 7. Correlation of Credit Grades between Credit Rating Companies
Correlation Coefficient with R&I
Moody'sCorrelation

S&P
Rank
Correlation

JCR

observation Correlation

Rank

observation Correlation

Correlation

Rank
Correlation

observation

1996

0.901

0.897

149

0.798

0.788

33

0.874

0.862

154

1999

0.891

0.895

227

0.868

0.879

153

0.947

0.932

336

2002

0.925

0.911

220

0.904

0.885

217

0.966

0.960

298

2004

0.609

0.463

171

0.292

0.28

202

0.637

0.635

211

Correlation Coefficient with Moody's
S&P

JCR

Correlation

Rank
Correlation

observation Correlation

Rank

observation

Correlation

1996

0.872

0.874

50

0.689

0.674

79

1999

0.907

0.906

157

0.833

0.812

117

2002

0.912

0.899

188

0.892

0.877

140

2004

0.682

0.674

167

0.363

0.436

141

Correlation Coefficient with S&P
JCR
Correlation

Rank
Correlation

observation

1996

0.854

0.883

16

1999

0.832

0.794

86

2002

0.902

0.876

151

2004

0.486

0.459

168

20

4.3 Disagreements by Industry
Generally speaking, some industries may be difficult to evaluate. It is interesting to show thedifferences in credit ratings by industry. Morgan (2003) found that there are significant
differences in raters’ evaluation regarding banks and insurance companies, while there is little
disagreement in evaluating other industries. That is, he found that there is 0.83 notch difference
regarding banks and 1.33 notch difference regarding insurance companies, while there is 0.65
notch difference regarding other industries15. Morgan concluded that these differences camefrom the fact that banks and insurance companies involved larger asymmetric information about
the quality of their assets and liabilities. This conclusion is consistent with Morgan and Stiroh(2001) and Flannery et al. (2002), which argued that it is very hard for outsiders to evaluate
commercial loans and other liquid financial assets16.
Unfortunately, Tables 6 and 7 suggest that 2004 data are problematic. So, we use 2002 data inthis sub-section. Table 8 shows the industry results (i.e., average absolute gaps). Here, weclassify all firms that have credit ratings from at least two credit rating companies into 21
industries17. Regarding R&I and Moody’s, there are more than 3 notch differences for nine
industries, while the difference for industry 20 (electric and gas) is the smallest. It is consistent
with Morgan (2002), which found the smallest disagreement over public utilities industry.
Surprisingly, the difference for banks is relatively small. We will investigate banks in more
depth in the next sub-section. Regarding Moody’s and S&P, Industry 7 (steel) recorded thelargest difference, followed by industry 1 (construction) and industry 19 (transportation).
Industry 15 (other finance) recorded the smallest difference. Finally, regarding R&I and JCR,
Industry 17 (Insurance) recorded the largest difference, and industries 10 (equipment fortransportation) and 15 (non-bank financial institutions) recorded the second largest, while
industry 4 (chemical) recorded the smallest difference.
We should be cautious to derive a definitive conclusion because many industry results are
based on small sample. It seems that there are no clear features about industrial differences. For
example, disagreement over insurance industry between R&I and JCR is the largest, while thatbetween R&I and Moody’s is the second smallest. Regarding other finance, disagreement
between R&I and JCR is the second largest, while that between Moody’s and S&P is thesmallest. Morgan (2002) found that disagreements between Moody’s and S&P over “other
15

These figures (i.e., average absolute gap) are cited from Table 2 of Morgan (2002).
Morgan (2002) ascertained that the fact that bank assets are mainly financial assets invites
agency problem because risks of loans to small business are hard to observe and trading assets
are easy to change.
17
Note that most of Japanese life insurance companies are mutual, not stock companies. As ourdata source included credit ratings regarding only listed companies, all firms belonging toinsurance sector in this chapter are general insurance companies, not life insurance companies.
16

21

finance” sector were smaller. He claimed that other finance sector was not so opaque because
they favored the asset-backed bonds. The unclear result regarding Japanese non-bank financemay be due to their different asset structures from their U.S. counterparts. Finally, the only
result that we can fairly conclude is that public utilities industry (i.e., industry 20) is the easiest
to evaluate.
Table 8. Credit Rate Differences by Industry (Average Absolute Gaps)
industry

Industry

code

R&I

Moody’s

R&I

vs.

vs.

vs.

Moody’s

S&P

JCR

1 Construction

3.00

1.88

0.85

2 Food

2.18

0.73

0.47

3 Fiber, pulp, and paper

3.25

1.67

0.82

4 Chemistry

3.00

0.45

0.40

5 Medicine

1.57

0.71

0.82

3.10

1.30

0.73

7 Steel, nonferrous metals, and other metal

2.58

2.80

0.88

8 Machine

2.40

1.25

0.63

9 Electric equipment

2.52

1.27

0.50

10 Equipment for transportation

2.56

0.63

1.25

11 Precision machine and other machine

2.70

1.00

1.00

12 Wholesale

2.75

1.40

0.79

13 Retail

3.09

1.42

0.83

14 Bank

1.74

1.32

1.06

15 Other finance

3.00

0.25

1.25

16 Securities

3.33

17 Insurance

1.43

1.00

1.50

18 Real estate

3.20

1.25

0.75

19 Transportation by land, marine and air, and warehouse

2.36

1.71

1.00

20 Electric and gas

1.38

0.69

0.76

21 Service

3.00

6

Oil, coal, rubber, the glass, and earth and stone
product

1.00

0.71

4.4 Disagreement over Bank Creditworthiness
Finally, we scrutinize disagreement over bank creditworthiness, which was actually a main22

research interest of Morgan (2002). Investigating Japanese bank case itself is also interesting
because of less transparent bank disclosure than U.S. banks and frequent bank failures in thelate 1990’s. Table 9(i) shows some measures of disagreement between R&I and Moody’s overJapanese banks. Although the average rating differences are still significantly large, differencesfor 2002 and 2004 are smaller than those for 1996 and 1999. Also, correlation coefficients (andrank correlation coefficients) increase. These findings suggest that the disagreement between
R&I and Moody’s over bank creditworthiness become smaller. However, disagreement between
Moody’s and S&P seems not to have any clear tendency. Namely, the gap for 2002 is larger thanprevious years, while the correlation between them for 2002 is the largest.
Table 9. Disagreement over Banks(i) R&I vs. Moody's
observations

Average rating

Average absolutecorrelation between

Rank

difference

gap

ratings

correlation

1996

6

-2.50

2.50

0.693

0.664

1999

23

-2.13

2.48

0.674

0.858

2002

27

-1.74

1.74

0.899

0.943

2004

25

-1.88

1.88

0.805

0.862

(ii)Moody's vs. S&P
observations

Average rating

Average absolutecorrelation between

Rank

difference

gap

ratings

correlation

1996

19

-0.37

1.11

0.625

0.699

1999

43

-0.93

1.02

0.787

0.785

2002

38

-1.31

1.31

0.832

0.811

2004

25

-0.76

0.84

0.745

0.770

5. Conclusion
The Japanese economy has drastically changed since the burst of the bubble, and the role ofbanks in Japanese economy has decreased. The government wants capital markets to play more
important roles and deregulates capital markets. Credit ratings are crucial for capital markets,
and we actually observe that credit rating companies enhance their influence. However, there is
no research to investigate whether how differently credit rating companies rate firms. Using
methodology that Morgan (2002) used, we find that the foreign credit rating companies tend toassign lower grade to Japanese firms than Japanese rating companies. And the differences23

among raters remain large, in spite of the disclosure and accounting rule reforms. However,when we focus on the correlation between scores of credit ratings, we find that credit ratingcompanies tend to agree more often on the relative risk evaluation. Although we need further
examination, we understand that the relative risks become easier to monitor due to the reforms.
We are also interested in investigating what sectors credit ratings more often disagree on.
Similar to Morgan (2002), we found that the smallest difference existed regarding evaluation on
public utilities sectors. Regrettably, we failed to find larger disagreements among credit ratingcompanies over banks and insurance companies.
Although we find several interests facts, we need further research. First, we only document thedisagreement among credit raging companies, but we do not consider why they disagree.
Insufficient information, their low ability or less-sophisticated experiences, and credit ratingcompanies’ risk preference may matter. Second, to directly compare U.S. market results with
our results, we have to use new issue bonds ratings regarding Japanese firms. Third, the rate
shopping is an interesting topic. Fourth, as argued in the text, it is interesting to examine theeffect of the enhancing role and influence of credit ratings companies on Japanese corporate
governance.

Acknowledgement
Yamori appreciates the Postal Life Insurance Culture Foundation (Kan-ihoken Bunka-Zaidan),the Ministry of Education, Science, Sports and Culture (Grant-in-Aid for Scientific Research)and Nomura Foundation for Promoting Academic Research for their financial supports. Allremaining errors, of course, are ours.

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