Information asymmetry, regulatory regime change, and market efficiency: The case of bond ratings and analysts’ earnings forecasts
Lisa Yang, Ph.D., Assistant Professor
Gary Caton, Ph.D., Associate Professor
Jake Jabs College of Business & Entrepreneurship
This project is an empirical test of relative information asymmetries associated with three separate regulatory regimes: (1) Pre-Regulation Fair Disclosure (Pre-RegFD), (2) post-RegFD and pre-Dodd-Frank Wall Street Reform and Consumer Protection Act (Pre-DF), and (3) post-DF. Ratified in 2000, RegFD was intended to reduce information asymmetries between various stock market participants, while maintaining the informativeness of bond ratings. RegFD did this by controlling information flows among market participants, while simultaneously exempting bond-rating analysts from those controls. In the wake of the Great Recession, DF eliminated this exemption thereby eliminating the bond-rating analysts’ information advantage. Using pre-RegFD data, Ederington and Goh (1998) show that earnings analysts tend to revise their forecasts immediately after bond ratings downgrades indicating an information flow from bond-ratings changes to earnings forecast revisions. We propose to test whether the information asymmetry implied by RegFD increases the information flow from bond raters to earnings analysts, and whether implementation of DF reduced or eliminated that flow.
Prior to RegFD, which the SEC ratified in October 2000, companies were free to discuss their business outlooks with whomever they pleased, and to exclude anyone they pleased. Companies could disclose information to favored earnings analysts who then had an unfair informational advantage over other analysts and the investing public. RegFD was implemented in order to level the playing field by requiring companies to disclose all material information to all members of the public simultaneously, with only one exception. Companies could continue to disclose non-public information to analysts at credit ratings agencies (CRAs). In 2010, DF revoked this exemption, thus eliminating the informational advantage provided by RegFD to CRAs. During this inter-regulatory period, after RegFD was ratified and before DF was implemented, CRAs had an informational advantage over other market participants.
President Obama signed DF into law in July 2010. The United States had just emerged from one of the worst recessions in history, a recession many accused the finance industry of precipitating. In this view, CRAs intentionally assigned unwarranted high ratings to subprime-mortgage-backed securities (subprime MBS) in order to continue to book revenues from the MBS’s originators. These overrated MBS were then sold to financial institutions all over the world as low-risk investments. When the subprime borrowers whose mortgages provided much of the collateral for these MBS began to default on their loans, large global institutions were put at risk of bankruptcy, which resulted in the bank bailout. DF, in part, revoked the CRA exemption provided by RegFD, thus ending bond-rating analysts’ informational advantage over earnings analysts.
Replicating Ederington and Goh (1998), we expect to find a positive relation between bond-rating downgrades and earnings forecast revisions in the pre-RegFD period. We posit that the implied information asymmetry associated with ratification of RegFD will lead to a stronger positive relation between ratings changes and forecast revisions in the inter-regulatory period. Finally, we posit that once DF eliminates the regulation-imposed information asymmetry, the relation between ratings downgrades and earnings forecasts diminishes in the post-DF period. This attenuation of relation implies that both bond ratings and earnings forecasts are less informative in the post-DF period than in the inter-regulatory period, which has serious implications for bond and stock market efficiency.
Significance of the Project
This work is a natural experiment for testing the effects of a regulation-imposed information asymmetry and its subsequent removal. The exemption from RegFD provided to CRAs makes the market more efficient in at least two ways. First, to the extent that individuals and institutions rely on bond ratings to make better-informed bond investment decisions, bond ratings reflecting the exempted private information make bond prices more informative, and the bond market more informationally efficient. Second, to the extent that market participants use earnings forecasts to make more informed stock investment decisions and bond-ratings changes inform earnings forecasts, stock prices are more informative, and the stock market is more informationally efficient, when CRAs are exempted from RegFD. Therefore, elimination of the CRA exemption from RegFD, which reduces the informativeness of bond ratings, reduces informational efficiency in both the bond and stock markets.
While we doubt the underlying intention of DF was to make the bond and stock markets less informationally efficient, this proposed study will study whether this is one of the unintended consequences of the Act. In order to make better decisions regarding regulatory reform, politicians and regulators need to know whether or not DF has detrimentally affected market efficiency. This project is a follow-on study to the one funded by the CRAEA last fall. That project studies whether the DF revocation of the exemption from RegFD carried with it a positive unintended consequence; a reduction in insider trading activity surrounding bond-rating changes. We believe this proposed study of market efficiency has the potential to be much more significant and timely to legislators and regulators who are currently considering changes to DF.