Credit Ratings and CEO Risk‐Taking Incentives

Abstract

This study examines the sophistication of rating agencies in incorporating managerial risk‐taking incentives into their credit risk evaluation. We measure risk‐taking incentives using two proxies: the sensitivity of managerial wealth to stock return volatility (vega) and the sensitivity of managerial wealth to stock price (delta). We find that rating agencies impound managerial risk‐taking incentives in their credit risk assessments. Assuming other things equal, a one standard deviation increase in vega (delta) will lead to an approximately one‐notch (two‐notch) rating downgrade. In addition, we evaluate the significance of credit ratings in the design of CEO compensation. Our findings suggest that rating‐troubled firms will gear down managerial incentives of risk seeking. In particular, other things equal, a rating downgrade to the lower edge of the investment category (i.e., BBB−) in the immediate prior year will bring about an approximately 51 percent reduction of vega incentive from options newly granted to the CEO in the current year. However, we find no evidence that firms' rating concerns significantly affect delta. Given the significance of credit ratings in the marketplace and their close connection to accounting, the findings of the current study advance our understanding, not only of how sophisticated rating agencies are in incorporating forward‐looking information (i.e., vega and delta) into risk assessments, but of how influential the raters are in changing firms' compensation policies. The findings also have implications on the role of accounting in constraining excessive managerial risk taking with improved disclosures on managerial compensation.

Managerial Ability and Credit Risk Assessment

“…As previously discussed, prior research (i.e., Kuang and Qin 2013) documents that increases in management risk-taking incentives (i.e., delta and vega) are associated with less favorable credit ratings (i.e., higher default risk). A potential concern is that these risk-taking incentives could be awarded to lowerability managers as a way to encourage them to take more risk and increase their default risk.…”

“…Although this evidence suggests that rating agencies take into account a broad range of financial characteristics, it is unclear from this evidence whether they consider the impact of managerial ability in their assessments of default risk. One study that does examine the effect of manager-level factors on credit ratings is Kuang and Qin (2013), which tests whether managerial risktaking incentives impact credit ratings. In particular, Kuang and Qin (2013) find that increases in management risk-taking incentives (i.e., vega and delta) are associated with lower ratings (i.e., higher default risk).…”

“…One study that does examine the effect of manager-level factors on credit ratings is Kuang and Qin (2013), which tests whether managerial risktaking incentives impact credit ratings. In particular, Kuang and Qin (2013) find that increases in management risk-taking incentives (i.e., vega and delta) are associated with lower ratings (i.e., higher default risk). 5 Management Science, Articles in Advance, pp.…”

“…Since risk-taking incentives are more likely to be awarded to higher-ability (not lower-ability) managers, these factors are likely to bias against our ability to find support for our prediction regarding the association between managerial ability and credit ratings. 25 In these supplemental tests we follow the method employed by Kuang and Qin (2013)-namely, linear estimation without year fixed effects. Our results are generally robust to using ordered logit estimation for the credit rating tests and including year fixed effects.…”

How Does the Credit Rating React to the Function of D&O Insurance?

“…Prior studies indicate that credit raters are sophistication, experience and use of portfolio strategies, they in incorporating both managerial risk-taking factors and managerial risk-mitigating strategies into their credit risk evaluation (Cheng and Neamtiu, 2009;Alp, 2013;Kuang and Qin, 2013;Bruno et al, 2016). Prior studies mainly focus on examining the association between credit ratings and financial quality/performance and demonstrate whether credit ratings provide a guarantee for default probability (Hribar and Jenkins, 2004;Lin et al, 2009;Beaver et al, 2012;Alissa et al, 2013).…”