Aurora Borealis
1 April 2014 CFA Institute Journal Review

Can Investor-Paid Credit Rating Agencies Improve the Information Quality of Issuer-Paid Rating Agencies? (Digest Summary)

  1. Clifford S. Ang, CFA

The information quality of ratings from an issuer-paid rating agency, such as Standard & Poor’s (S&P), changed when investor-paid rating agency Egan-Jones Rating (EJR) entered the market. The author finds that after EJR’s coverage began, S&P’s ratings were more responsive to changes in credit risk and that the market reacted more to S&P’s rating changes.

What’s Inside?

The author studies how the information quality of ratings from an issuer-paid rating agency, in this case Standard & Poor’s (S&P), responded to the entry of an investor-paid rating agency—Egan-Jones Rating (EJR). He finds that after EJR’s coverage began, S&P’s ratings were more responsive to changes in credit risk and that the market reacted more to S&P’s rating changes. This result differs from findings of prior research regarding the effects of adding a new issuer-paid rating agency.

How Is This Research Useful to Practitioners?

The author’s findings are useful to practitioners for at least two reasons. First, the findings indicate that investor-paid rating agencies improve the quality of ratings actions by issuer-paid rating agencies. Specifically, the author finds that after EJR initiated coverage, S&P’s ratings quality became three times more responsive to changes in credit risk. In contrast, prior research found that the entry of Fitch Ratings, a third issuer-paid rating agency, resulted in even less informative and more issuer-friendly ratings from the incumbents. According to the author, the reason was because Fitch’s entry put pressure on S&P and Moody’s Investors Service to cater to issuers’ demands via inflated and less informative ratings.

Second, the results show that negative ratings actions announced by issuer-paid rating agencies are more informative following the initiation of coverage by investor-paid rating agencies. In particular, the author finds that since EJR coverage began, investors react more to S&P’s negative rating changes than to S&P’s positive rating changes. The higher reputational cost to rating agencies for their failure to reveal negative information compared with a failure to reveal positive information can explain this asymmetrical result.

How Did the Author Conduct This Research?

The author uses EJR’s ratings database consisting of issuer credit ratings from July 1999 to the end of 2011. The EJR data are then merged with S&P and Compustat data, resulting in approximately 12,000 observations representing 588 firms that were originally covered by S&P and later covered by EJR between 1999 and 2011.

To show the increased quality of S&P’s ratings, the author examines the expected default probability derived from the Merton/KMV framework and its correlation with S&P’s ratings. A higher correlation indicates that S&P’s ratings are more responsive to credit risk. The author finds weak correlation prior to EJR’s coverage and stronger correlation after EJR’s coverage.

In his analysis of the market reaction to rating change announcements by S&P, the author uses the event study methodology. An event study is a commonly used technique in financial economics to estimate the information content of news announcements. Specifically, the author analyzes downgrades and upgrades of S&P ratings before and after EJR began coverage. He then measures the market reaction around a three-day event window surrounding the rating change announcement. The author finds downgrades are associated with a more negative reaction during the post-coverage period, which suggests that S&P’s ratings bear higher information content. The result for the upgrades did show a positive market reaction, but the result was not statistically significant.

The author then uses three complementary approaches to establish the causal role of EJR’s coverage on S&P’s rating strategies. He finds that S&P’s response to EJR’s coverage seems to occur only when EJR’s ratings are lower than S&P’s existing ratings. This asymmetrical result suggests that S&P does not simply mimic EJR’s information.

Abstractor’s Viewpoint

The incentive problems that are posed by having ratings paid for by the issuer are clear, but investors hope that the reputational harm to the rating agency is more than sufficient to mitigate such conflicts of interest. The results of this research help alleviate that concern because the author shows that the entry of investor-paid rating agencies keeps issuer-paid rating agencies in check and, in the process, makes issuer-paid rating agency actions more timely and informative.

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