Paper Spotlight: Do Security Analysts Discipline Credit Rating Agencies?

Kingsley Fong

Harrison Hong

Marcin Kacperczyk

Jeffrey D Kubik







Credit ratings agencies are important players in financial markets and they could contribute to efficient resource allocations through information generation. Often, though, expectations of this positive impact are not met in reality because of well-documented biases that credit rating agencies suffer from. Such issues can be due to revolving doors, home biases, and political beliefs of credit analysts. These biases can ultimately have a significant nefarious effect on debt prices.

One big question is the source of these biases. This is an important question because if we want to move closer to a state where markets work efficiently we need to eradicate or limit such biases.

In the paper “Do Security Analysts Discipline Credit Rating Agencies?” Kingsley Fong, Harrison Hong, Marcin Kacperczyk, and Jeffrey D. Kubik investigate one important force that could be driving these credit rating agencies biases: information spillovers from equity markets to credit ratings. The paper argues that credit rating agencies find it harder to issue high grades for a firm’s debt when the firm’s informational environment is strong due to the presence of equity analyst reports that are informative about a firm’s distance-to-default. The authors’ argument is predicated on two related arguments: first, theory shows that a firm’s price of both debt and equity claims should be based on the same underlying fundamental value, and, second, evidence shows that equity prices often lead credit ratings and are crucial in the determination of credit spreads.

Using a diff-in-diff framework around an exogenous drop in analyst coverings, the authors show that a decrease in information generated by security analysts increases the subsequent debt ratings of a firm by around a half-rating notch. There is, in other words, greater optimism-bias in credit ratings when there is a lower presence of security analysts, especially for firms with little bond analyst coverage to begin with, and for firms that are close to default. This coverage-induced shock also leads to less informative ratings for future default and downgrading events, and bond-level mispricings.

Spotlight by Andrew Ellul
Photos courtesy of Kingsley Fong, Harrison Hong, Marcin Kacperczyk, and Jeffrey D Kubik

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