Essays on credit ratings

Field: Economics, Econometrics and Finance (Social Sciences)

This PhD thesis consists of three independent empirical research papers about credit \nratings and the connection between credit ratings and the financial market. \nA credit rating agency (CRA) is a third-party financial institution providing \nassessments and recommendations for other market participants about the \nperformances of firms, the default risk of financial instruments issued by those firms \nand the credit quality of sovereign countries who issue government debts. On account \nof the essentiality of information transparency in the modern financial system, the \ncredit rating industry is gaining importance in terms of its role as an information-provider \nfor market participants and of its function to reduce the information \nasymmetry in the financial market. Due to this significant importance, CRAs may \nimpact the behaviors of market participants by offering signals about the firms or \nfinancial instruments and hence have a strong influence on the stability of the financial \nmarket. The aim of this PhD thesis is to discuss the relationship between credit ratings \nand the financial market from three perspectives: the link between sovereign ratings \nand firm’s performances in the context of the European debt crisis, the role of credit \nratings in the pricing of asset-backed securities (ABS) before and after the global \nfinancial crisis, and the motivation of self-interests of the CRA industry. \nIn the first empirical paper, I investigate the shock of sovereign downgrades and the \nassociation between them with the performances of listed banks which are registered \nin the downgraded countries. The previous literature shows the connection between \nsovereign ratings and bank performances and hypothesizes some potential channels \n(such as the government debt and government guarantee) by which sovereign ratings \nimpact bank performances. Nonetheless, individual bank ratings are neglected in \nthese analyses. I fill in this gap by studying the role of bank ratings in the transmission \nof effects of sovereign downgrades on bank performances. I find that sovereign rating \ndowngrades followed by bank rating changes have a stronger impact on the bank \nstock returns and Z scores (a proxy of the bank insolvency risk) than those which are \nnot followed by bank rating changes. To further tease out the independent effect of \nsovereign and bank rating downgrades, I take advantage of ‘sovereign-ceiling policy’ \nwhich creates the semi-passive bank rating downgrades when the sovereign rating \nceiling has been downgraded. The empirical tests of the banks downgrades triggered \nby the sovereign ceiling policy help us to conclude that bank rating downgrades \nprovide extra information to the market even if they occur no more than two days after \nthe sovereign ratings are downgraded. \nIn the second empirical paper, I focus on the ABS market and the role of CRAs in the \ndetermination of ABS prices. I investigate whether the reactions of ABS investors to \ncredit ratings have significantly changed since the shock of the global financial crisis. \nTo empirically test the ABS investors’ behavior, I run a series of regressions to study \nthe correlation between ABS issuance spread and the issuance credit ratings in pre-and \npost-crisis periods. I find evidence of a weaker reaction of ABS investors to the \nratings offered by credit rating agencies after the financial crisis. To supplement the \nstatic-regression analysis, I apply event-analysis methods to identify the ABS price \nreactions to the rating events in the two periods and identify weaker price reaction \ndegrees after the crisis. The conclusion is that before the 2008 crisis, ABS investors’ \ndecisions, reflected by both the issuance spread and transaction prices, were \nsignificantly associated with the ratings offered by CRAs while the post-crisis period \nhas seen a weaker link between spread/prices and CRAs’ announcements, indicating \na smaller influence of CRAs on the ABS market. \nThe third empirical paper discusses CRA self-interests from the perspective of the \nassociation between rating solicitation status and the conservatism as well as the \nquality of rating services. It contributes the literature by applying the gap between \nunsolicited and solicited ratings as a measurement to investigate the motivation of \nCRAs. Based on a simplified theoretical model, I raise the hypothesis of self-selection \nto demonstrate the motivation of firms who do not solicit rating services and the \nrationality of rating agencies’ decision to offer ratings with more conservative levels \nfor unsolicited rating recipients. Firms who realize that their future performances will \ndeteriorate are less likely to solicit ratings from rating agencies. Rating agencies \ncapture this signal and offer unsolicited ratings to those firms with a more conservative \nrating reflecting the self-selection effect. I empirically test this hypothesis using \nMoody’s unsolicited rating data and I obtain two findings. The first finding is that \ncontrolling for fundamental factors, Moody’s unsolicited ratings are lower than \nsolicited ones. The second finding is that the rating qualities of both types of ratings \nare not significantly different from each other. \nMy research contributes to both the academic literature and the practical field of the \ncredit rating industry by providing a comprehensive discussion on the connection \nbetween a variety of credit rating services (sovereign ratings, firm ratings and bank \nratings) and the market reactions (issuance and transaction prices, insolvency risk \nand default risk) in different cases (the structured finance products, the sovereign \nceiling policy and the issuance of unsolicited ratings). The study also investigates the \nshock of two recent financial crises (global financial crisis and European debt crisis) \non the credit rating industry, which provides suggestive findings for the regulators who \nare willing to take some actions to intervene in the CRA industry in order to enhance \nthe stability of financial markets in the post-crisis era.