Are Credit Ratings Informative? Evidence from Regulatory Regime Changes
Lisa Yang, Ph.D., M.Sc., B.Sc., Assistant Professor, Jake Jabs College of Business and Entrepreneurship
Section 939A of the Dodd-Frank Act aims to remove reference on credit ratings in federal government statues and regulations. To shed light on its potential influence on the efficiency of financial markets, we proposal to study the informational contents of credit rating actions including both credit watch placements and credit rating changes. Using the recent repeal of Credit Rating Agencies’ (CRAs) exemption from Reg FD as a quasi-natural experiment, we test three competing hypotheses as to whether and why credit ratings are informative. (1) CRAs have access to non-public information, (2) CRAs rely on their reputation to certify the firms they rate, (3) A shift in demand for specific securities due to ratings-contingent regulations. We expect to find evidence of the relation between rating-dependent regulations and the informativeness of CRAs on both stock and bond markets, and thus provide policy implications.
The SEC’s introduction of Nationally Recognized Statistical Rating Organizations (NRSROs) encouraged increased statutory reliance on ratings over the past three decades. These rules required that certain investors such as banks, pension funds, and insurance companies could only invest in bonds with high ratings. Other rules reduced capital requirements for institutions that purchased highly rated bonds. As such, firms and financial market institutions rely heavily on the ratings and these Credit Rating Agencies (CRAs) who are certified as NRSROs, to make investment and capital budgeting decisions. However, CRAs have come under intense scrutiny for warning investors late of the declining credit quality and for providing overly optimistic ratings for structured finance products such as mortgage-backed securities (MBS) that promulgated the subprime mortgage crisis of 2008.
The growing skepticism has culminated in tighter regulation of credit rating agencies under Dodd–Frank Act that was signed into law on July 21, 2010. Section 939A of Dodd-Frank Act aims to reduce statutory reliance on credit ratings assigned by NRSROs. A theory proposed by Opp, Opp, and Harris (2013) suggests that statutory reliance on CRAs may cause the collapse of delegated information acquisitions, as CRAs may engage in rating inflation. Their model further predicts that a reduction in statutory reliance on CRAs is likely to improve CRAs’ incentives to acquire information, and hence rating accuracy.
This research aims to provide empirical evidence on whether rating-contingent regulations affect the informativeness of credit ratings and thus provide policy implications for the ongoing removal of rating reference. Specifically, we exploit the recent repeal of CRAs’ exemption from Regulation Fair Disclosure (henceforth the Repeal) to study the informational content of bond ratings. Prior to Regulation Fair Disclosure (Reg FD), which was ratified by the SEC in October 2000, companies were basically free to disclose non-public information with whomever they pleased. Reg FD banned selective disclosure of non-public information to favored stock analysts or investors. However, Reg FD explicitly exempted the rating agencies, allowing management to share non-public information with rating agencies. Section 939B of the Dodd-Frank Act, enacted in 2010 revoked the rating agencies’ exemption from Reg FD, thus eliminating the informational advantage provided by Reg FD to CRAs. Therefore, credit rating agencies informational advantage should be eliminated after the Repeal.
We will study both stock and bond price responses to credit rating actions across regulatory regimes. Then we will distinguish what is the driving factor for the informational contents of credit ratings. If rating-contingent regulations are the driving force, then we expect to find that significant stock price responses to both credit watch placements and actual rating changes disappear after the Repeal, whereas bond price responses remain significant. We also expect that these results are stronger at the investment-speculative boundary. Therefore, our study will establish the relation between rating-dependent regulations and informativeness of credit ratings and provide implications for ongoing regulatory changes such as the Section 939A of Dodd Frank Act.
Significance of the Project
We believe the significance of our intended work for regulatory authorities will be 1) to provide empirical evidence on whether the informativeness of credit ratings is driven by the rating-dependent regulations; 2) to have policy implications for the ongoing regulatory changes that aim to create a level playing field for non-NRSROs. Since the removal of reference on credit ratings (e.g. Section 939A of Dodd Frank) will involve all federal government statues and regulations, its impact on the financial markets and institutions will be substantial.