How Rating Agencies’ Market Power Affects Credit Rating Standards

Global credit rating agencies (CRAs) like S&P and Moody’s are important gatekeepers for the debt market. The demand for their ratings has increased at an unprecedented rate in the past two decades due to an extraordinary growth in cross-border debt financing. While the global CRAs’ market dominance has been the subject of considerable attention and regulatory debate, we know little about how their overall market power affects rating standards and quality. One reason is that prior studies generally focus on the U.S. market, where S&P and Moody’s already command a more than 90 percent  share. In a forthcoming paper, we examine this issue using a global sample.

We predict that corporate credit ratings become more stringent when global CRAs have greater market power. This prediction stems from the intuition that the reputational penalties for biased ratings in the corporate bond market are asymmetric because CRAs are penalized for ratings that are optimistically but not pessimistically biased. To protect their reputation, CRAs may lower their ratings beyond the level justified by an issuer’s fundamentals. When the global CRAs’ market shares and client base expand, the agencies’ concerns about long-term reputation losses become stronger, leading the CRAs to tighten their rating standards. In contrast, when global CRAs’ market shares and client base decline, the CRAs have an incentive to generate business by issuing favorable ratings that cater to issuers’ demands.

Using a global sample across 26 countries from 1994 to 2019, we first document a significant cross-country variation in S&P and Moody’s market power, as measured by their respective country-level market shares. For example, these credit rating agencies capture more than 80 percent of new bond issuances in Germany, Italy, and the U.K and less than 50 percent in South Korea, Singapore, and Switzerland. The market shares of S&P and Moody’s are also highly correlated, suggesting that these agencies are probably not competing with each other. Rather, the competition for S&P (or Moody’s) likely comes from local credit rating agencies in domestic bond markets.

Next, we find that greater market power of global CRAs is associated with stricter corporate ratings. For a one standard deviation of change in the market share in the non-U.S. sample, average ratings are predicted to decrease by 0.118 notches, which corresponds to a downgrade of one rating notch (e.g., AA to AA-) for approximately one out of every 10 firms in a country. In addition, the increase in global CRAs’ market shares contributes to the tightening trend in their credit ratings worldwide.

To bolster our causal inferences, we conduct a test that exploits an exogenous shock to the global CRAs’ market power: the designation of a local competitor as a Nationally Recognized Statistical Rating Organization (NRSRO). Specifically, we use the U.S. SEC’s 2007 designation of two Japanese CRAs, JCR and R&I, as a NRSRO. Because an NRSRO designation of local CRAs is determined by the SEC, it can be considered relatively exogenous to the rating behavior of global CRAs. We find that S&P’s market share in Japan decreased following these events. Using firms in other Asia Pacific countries as the benchmark sample, our analysis finds that S&P’s corporate ratings of Japanese firms were higher after the designation of local CRAs as the result of S&P’s decreasing market power in Japan after the designation.

We further assess the implications of global CRAs’ market power on the accuracy, timeliness, and pricing of corporate credit ratings. We find that, while stricter ratings from greater market power lead to a reduction in the likelihood of missed defaults, this reduction comes at the expense of more false warnings. Moreover, ratings  reflect negative information faster when S&P’s market share is higher, as the equity market reacts more negatively to rating downgrades, and the likelihood of rating downgrades is more positively associated with the expected default frequency. These findings are consistent with greater market power of global CRAs leading to higher reputational concerns.

Collectively, our findings suggest that global rating agencies’ market power leads to stricter rating standards and timelier ratings by strengthening the agencies’ reputation concerns, but at the expense of increased false warnings. Our study has important policy implications. Citing the market dominance of a few CRAs, regulators have called for increasing competition in the industry. In the European Union, rules have been enacted to make it easier for new rating agencies to enter the market. Yet, our study suggests that the global CRAs’ market power may discipline rating standards with greater reputation effects, leading to tighter rating standards in corporate bond markets. We caution, however, that the CRAs’ market dominance may also have negative effects, such as increasing false warning signals and discouraging innovation and investment.

This post comes to us from Mingyi Hung at Hong Kong University of Science and Technology, Pepa Kraft at HEC Paris, Shiheng Wang at Hong Kong University of Science and Technology, and Gwen Yu at the University of Michigan. It is based on their recent article, “Market Power and Credit Rating Standards: Global Evidence,” forthcoming in the Journal of Accounting and Economics and available here.

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