Testing Conflicts of Interest at Bond Rating Agencies with Market Anticipation: Evidence that Reputation Incentives Dominate

Abstract

This paper presents the first comprehensive test of whether well-known conflicts of interest at bond rating agencies importantly influence their actions. This hypothesis is tested against the alternative that rating agency actions are primarily influenced by a countervailing incentive to protect their reputations as delegated monitors. These two hypotheses generate a number of testable predictions regarding the anticipation of credit-rating downgrades by the bond market, which we investigate using a new data set of about 2,000 credit rating migrations from Moody's and Standard & Poor's, and matching issuer-level bond prices. The findings strongly indicate that rating changes do not appear to be importantly influenced by rating agency conflicts of interest but, rather, suggest that rating agencies are motivated primarily by reputation-related incentives.1 This goal is articulated in Moody's (2003), for instance. 2 In other settings, it has been shown that reputations mitigate moral hazard problems, as in Diamond (1991). Of course, there are also examples of when reputations are ineffective (as in Bulow and Rogoff, 1989).

Credit rating announcements, trading activity and yield spreads: the Spanish evidence

“…The same effects are affirmed by the moral hazard risk problem (Covitz and Harrison, 2003). Whereas the market is the end customer of rating agencies, almost all their revenues come from rating fees paid by the rated firms.…”

“…These positive rating events do not contain pricing-relevant information. Explanations can be found in previously posited hypotheses about an asymmetric price reaction, such as the reputation hypothesis (Holthausen and Leftwich, 1986) and the moral hazard risk problem (Covitz and Harrison, 2003).…”

“…Infrequent trading and the use of transaction prices prevent consideration of most of these benchmarks, such as bond indexes, bonds with similar features or corporate yield curves. Hite and Warga (1997) and Covitz and Harrison (2003) use a bond index having the same broad rating and maturity classification as the bond in question, but there are no trustworthy corporate bond indexes in the Spanish case. 13 Gropp and Richards (2001) estimate a market model from quotes, in which a government bond index acts as the market indicator.…”

Rating Alignment, Rating Shopping and Reputation of Credit Rating Agencies: Evidence from the Subprime Crisis

“…Indeed, Covitz and Harrison (2003) find some support for this view, showing that the timing of downgrades does not relate to issuer interest and importance as a customer for the CRA. However, this argument understates three nontrivial considerations: the impact of economic cycles on both (a) the monitoring of CRA behavior and (b) CRAs rating reliability; and (c) the potential gain coming from inflated ratings on complex structured securities when fees are significant.…”

The Credit Rating Industry: Competition and Regulation

“…Competitors, in turn, would lose their business opportunities through such rating actions. However, empirical studies find no evidence for conflicts of interest affecting business behavior (Covitz andHarrison 2003, p. 23 andButler andRodgers 2003, p. 19). The results suggest that profits from misusing the quality scope ε are smaller than potential costs.…”