Do Rating Agencies Behave Defensively for Higher Risk Issuers?

Samuel B. Bonsall (), Kevin Koharki (), Pepa Kraft (), Karl A. Muller () and Anywhere Sikochi ()
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Samuel B. Bonsall: Accounting Department, The Pennsylvania State University, University Park, Pennsylvania 16802
Kevin Koharki: Accounting Department, Purdue University, West Lafayette, Indiana 47907
Pepa Kraft: Department of Accounting and Management Control, HEC Paris, 78350 Jouy-en-Josas, France
Karl A. Muller: Accounting Department, The Pennsylvania State University, University Park, Pennsylvania 16802
Anywhere Sikochi: Department of Accounting and Management, Harvard University, Cambridge, Massachusetts 02163

Management Science, 2023, vol. 69, issue 8, 4864-4887

Abstract: We examine whether rating agencies act defensively toward issuers with a higher likelihood of default. We find that agencies’ qualitative soft rating adjustments are more accurate as issuers’ default risk grows, as evidenced by the adjustments leading to lower type I and type II error rates and better prediction of default and default recovery losses. We also find that soft adjustments’ relevance increases with issuers’ default risk, as evidenced by the adjustments being more predictive of initial offering yields and leading to a greater market reaction to rating changes. Further, we find that the rating agencies assign better educated and more experienced analysts to higher-risk issuers, providing evidence of one mechanism used by the rating agencies to generate more accurate and relevant soft adjustments. Overall, our study suggests that as the likelihood of issuer default grows, the threat of reputational harm from discovered rating failures increasingly mitigates the rating agencies’ strategic behavior incentivized by the issuer-pay model.

Keywords: credit rating agencies; soft rating adjustments; default (search for similar items in EconPapers)
Date: 2023
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Citations: View citations in EconPapers (1)

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