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This paper studies the use of performance pricing (PP) provisions in debt contracts and compares accounting-based with rating-based pricing designs. We find that rating-based provisions are used by volatile-growth borrowers and allow for stronger spread increases over the credit period. Accounting-based provisions are employed by opaque-growth borrowers and stipulate stronger spread reductions. Further, a higher spread-increase potential in rating-based contracts lowers the spread at the loan’s inception and improves the borrower’s performance later on. In contrast, a higher spread-decrease potential in accounting-based contracts lowers the initial spread and raises the borrower’s leverage afterwards. The evidence indicates that rating-based contracts are indeed employed for different reasons than accounting-based contracts: the former to signal a borrower’s quality, the latter to mitigate investment inefficiencies.
Under a new Basel capital accord, bank regulators might use quantitative measures when evaluating the eligibility of internal credit rating systems for the internal ratings based approach. Based on data from Deutsche Bundesbank and using a simulation approach, we find that it is possible to identify strongly inferior rating systems out-of time based on statistics that measure either the quality of ranking borrowers from good to bad, or the quality of individual default probability forecasts. Banks do not significantly improve system quality if they use credit scores instead of ratings, or logistic regression default probability estimates instead of historical data. Banks that are not able to discriminate between high- and low-risk borrowers increase their average capital requirements due to the concavity of the capital requirements function.