An Empirical Analysis of the Effects of the Dodd-Frank Act on Determinants of Credit Ratings

Abstract

We study the effects of the Dodd-Frank Act (“Dodd-Frank”) on determinants of credit ratings. We predict that the increase in regulatory oversight and litigation risk prompted by Dodd-Frank, as well as requirements for improved disclosures and governance, motivated credit rating agencies (CRAs) to increase the reliance on firm-specific, quantitative fundamental information in determining ratings. We find that the power of firm fundamentals in explaining credit ratings increases significantly after Dodd-Frank. We also show that the association between ratings and certain firm-specific fundamentals is stronger in the post-Dodd-Frank than in the pre-Dodd-Frank period. Furthermore, we find that the greater reliance on firm fundamentals at least partially drives the improvement in credit ratings’ ability to predict future defaults. Collectively, our evidence suggests that Dodd-Frank incentivizes CRAs to use more quantitative information in making rating decisions, which improves credit rating quality.