Credit ratings play a significant role in firms’ access to capital, in corporate debt contracts, in state and global regulations, and more. But what affects the ratings and how they are determined? These questions are crucial especially in the shadow of credit rating agencies’ destructive role in prompting the 2007-8 financial crisis.
This interesting paper “Is There a Relationship Benefit in Credit Ratings” (free access) shows that credit ratings are not about financial economics or sophisticated methodology, rather they are about social networks: firms with longer rating agency relationships have better credit ratings (i.e., closer to AAA), conditional on observables.
Based on a large US sample of 1,263 publicly traded firms (and their bonds), being rated by S&P for at least three consecutive years over the period 1986–2005, Thomas Mählmann (University of Cologne) presents important empirical findings: (1) controlling for observables, firms with longer relationships, while having higher average ratings, do not have lower default rates, (2) relationship benefits are larger among firms with a greater incentive to game their information supplied to agencies or to pressure agencies into giving higher ratings, and (3) investors demand a (price) discount on bonds sold by relationship firms and the correlation between bond yield spreads and ratings is decreasing with relationship length.
In sum, the evidence is inconsistent with first-order credit quality mainstream explanations. Bear it in mind, while you are constantly overwhelmed with credit ratings reports regarding corporations and countries. Moreover, as we already know, sometimes it’s not just about social ties, but also about the agendas underpinning the (mis)use of numbers.
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[…] Credit rating is NOT about economics and methodology; it’s about social networks and relations… […]