Impact of the Dodd-Frank Act on Credit Ratings

In response to the Global Financial Crisis of 2008-2009, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in July 2010. Among its various provisions, Dodd-Frank outlines a series of broad reforms to the Credit Rating Agencies (CRA) market. Many observers believe that CRAs’ inflated ratings of structured finance products were partly to blame for the rapid growth and subsequent collapse of the shadow banking system. In response, Dodd-Frank’s CRA provisions significantly increase CRAs’ liability for issuing inaccurate ratings, and make it easier for the SEC to impose sanctions and bring claims against CRAs for material misstatements and fraud.

In our paper, Impact of the Dodd-Frank Act on Credit Ratings, forthcoming in the Journal of Financial Economics, we examine whether Dodd-Frank achieves its stated objective of improving the quality of credit ratings, or whether the law unintentionally leads to a loss of relevant information in the CRA market. The quality of credit ratings may improve as the law encourages CRAs to invest in due diligence, strengthen internal controls and corporate governance, and improve their methodology (disciplining effect). Alternatively, CRAs may respond to the greater threat of legal and regulatory action by lowering their ratings beyond a level justified by an issuer’s fundamentals (reputation effect). Doing so helps CRAs protect their reputation in a market where issuing overly optimistic ratings is expected to have far greater legal and regulatory costs than issuing overly pessimistic ratings. As CRAs lower their ratings regardless of their information, investors rationally discount CRAs’ rating downgrades and some valuable information is lost to the market.

Using a comprehensive sample of corporate credit ratings from 2006 to 2012, we find strong support for the reputation effect. We document:

• Lower corporate bond ratings, on average, in the post-Dodd-Frank period (defined as the period from July 2010 to May 2012). The odds that a corporate bond is rated as non-investment grade are 1.19 times greater after the passage of Dodd-Frank, holding all else constant.
• More false warnings in the post-Dodd-Frank period, where false warnings are defined as speculative grade rated issues that do not default within one year. The odds of a false warning are 1.84 times greater after the passage of Dodd-Frank, holding all else constant.
• Lower bond market reaction to credit rating downgrades (but not to credit rating upgrades) in the post-Dodd-Frank period. Prior to the passage of Dodd-Frank, bond prices decrease on average by 1.023% following a rating downgrade; this compares to a decrease of 0.654% following the passage of Dodd-Frank.
• Lower stock market reaction to credit rating downgrades (but not credit rating downgrades) in the post-Dodd-Frank period. Stock prices decrease by 2.461% following a rating downgrade in the pre-Dodd-Frank period; in the post-Dodd-Frank period, the decrease is only 1.248%.

To summarize, credit ratings are lower, less accurate, and less informative to the market following the passage of Dodd-Frank. It appears that the reputation effect outweighs the disciplining effect of Dodd-Frank in the market for corporate bond credit ratings.

To better identify the effect of reputation on our findings, we divide the CRA market in two segments according to the relative importance of CRA reputation in each segment. Becker and Milbourn (2011) show that Moody’s and Standard and Poor’s invest more in reputation in industries where they face less intense competition from Fitch. Hence, if our findings are driven by CRAs’ reputation concerns, then credit ratings post-Dodd-Frank should be lower, less accurate, and less informative primarily in industries with lower Fitch market share. When Fitch’s market share is lower, legal and regulatory penalties have higher expected reputation costs to Moody’s and S&P in terms of lost future rents. Consistent with a reputation effect, we find stronger results within industries with low Fitch market share. Within industries in the bottom quartile of Fitch market share, the passage of Dodd-Frank increases the odds of a non-investment grade rating 2.27 times, increases the odds of a false warning 8.21 times, reduces the reaction of bond prices to downgrades by 1.083%, and reduces the reaction of stock prices to downgrades by 2.976%.

Taken together, our findings indicate that Dodd-Frank has led to a loss of information in the market for corporate credit ratings. These findings can inform regulators and policymakers who continue to debate the best way to restructure the credit rating industry. The common wisdom is that increasing the penalties for biased ratings will discipline CRAs to provide higher quality ratings. However, as we show in this paper, CRAs respond to the increased regulatory pressure by issuing lower, less informative corporate bond ratings to protect their reputation. Any regulatory scheme for CRAs should carefully consider the trade-off between these two effects.

The full paper is available for download here.