Director Networks and Credit Ratings

In the aftermath of the most recent financial crisis, credit rating agencies (CRAs) once again received a portion of the blame.  Similar to the negative CRA attention that followed the Asian Financial Crisis in 1997 and the dot.com bubble of the early 2000s, CRAs were called on the carpet to answer for the inaccuracy of their rating assignments, this time as they pertained to mortgage backed securities.

CRAs operate at an information disadvantage, and one way in which they attempt to close this gap is through communications with the firm of interest.  CRAs don’t just bestow a rating on a company or a specific issue.  Instead, there is an ongoing dialogue between the CRA and the firm that allows the CRA to reduce information asymmetry. Therefore, rather than rely entirely on the financial picture of a firm, a rating also reflects a human element.

Previous research has focused on the relationships between a board of directors and the agents of the CRAs, revealing that these relationships lead to higher credit ratings. [1]  The argument is that information flows more freely between connected individuals.  In our recent paper, available here, we argue that connections on a broader level can aid a firm in receiving a good credit rating.  Our hypothesis is motivated by the idea of social capital and the “deepest definition of social capital deals with trust.”[2]  We surmise that high levels of trust are likely to be beneficial in financial contracts.  People may increase their social capital by increasing their social connections.[3]  As an individual’s personal network (through education, work, family or recreation) increases, that person is viewed as more trustworthy.  Knowing this, we investigate how the social capital of a firm’s board of directors can influence rating decisions.

We first test whether there is a relationship between the social capital of the board of directors and a firm’s credit rating.  We find that firms that employ directors with low social capital are associated with lower credit ratings.  We also see that firms can increase their credit rating by adding board members who are more connected (have more social capital).  Once again, our results show that it’s not just the connections the board has with the CRAs.  Instead, it’s the connections that a firm’s board of directors has with an entire financial community.

Second, we focus on the financials of a firm and then introduce our social capital variable.  We find that firms with well-connected directors have higher credit ratings than the financial snapshot would otherwise predict.  We attribute this finding to CRAs being more comfortable assigning a higher rating to a firm that has trusted, well-known directors.  This result is most pronounced for the most distressed firms.  By definition, a trusted director is more likely to do his part and adhere to a sense of duty, thus partially alleviating CRA concerns.

Next, we investigate how the social capital of the board affects credit ratings during economic recessions.  It has been shown that credit ratings are overly pessimistic during recessions. [4]  CRAs err on the conservative side during economic slowdowns and assign ratings that may be lower than warranted.  We show that having a well-connected board can mitigate this effect.  When there are increased levels of economic uncertainty, the main agents become more important.  The increasing information asymmetry associated with economic downturns makes the qualitative part of rating analysis more valuable.

Finally, we investigate the benefits of social capital around the investment grade cut-off.  Traditionally, the move from investment grade to non-investment grade is associated with the largest increase in cost of debt.  Additionally, firms that see their ratings move from investment grade to high yield status are also losing many institutional investors who are constrained by bylaws which prevent them from holding the securities of non-investment grade firms.  Our results show that a well-connected board can help push a firm to the coveted investment grade status and give those firms access to more investors.

In summary, our paper shows one of the economic benefits associated with employing a board with large social capital.  A firm that has a board with well-connected directors is viewed as more trustworthy in the financial markets.  Financial contracts and the terms of those contracts are a function of the trustworthiness of the borrowers.  If the main agents in a firm are considered trustworthy due to their extensive personal connections, it then follows that that benefit is transferred to the firm’s financial contracts.  Specifically, well-connected boards are associated with higher credit ratings.  These firms then enjoy lower operating costs and greater access to the capital markets.

ENDNOTES

[1] Khatami, S.H., M.T. Marchica, and R. Mura, 2016, “Rating Friends: The Effect of Personal Connections on Credit Ratings,” Journal of Corporate Finance 39, 222-241.

[2] Paldam, M., 2000, “Social capital: one or many? Definition and measurement,” Journal of Economic Surveys, 14(5), 629-653.

[3] Putnam, R. D., 1995, “Bowling Alone: America’s Declining Social Capital,” Journal of Democracy 6, 65-78.

[4] Auh, J.K., 2014. “Essays on Corporate Credit,” Columbia University Working Paper

This post comes to us from Bradley W. Benson and Kristopher Kemper, professors at Ball State University, and from Professor Subramanian R. Iyer at the University of New Mexico and Professor Jing Zhao at Portland State University. It is based on their recent paper, “Director Networks and Credit Ratings,” available here.