Procyclical Credit Rating Policy

Abstract

This paper studies whether credit rating agencies applied consistent rating standards to U.S. corporate bonds over the expansion and recession periods between 2002 and 2011. Based on estimates of issuing firms’ credit quality from a structural model, I find that rating standards are in fact procyclical: ratings are stricter during an economic downturn than an expansion. As a result, firms receive overly pessimistic ratings in a recession, relative to during an expansion. I further show that a procyclical rating policy amplifies the variation in corporate credit spreads, accounting for, on average, 11 percent of the increase in spreads during a recession. In the cross section, firms with a higher rollover rate of debt, fewer alternative channels to convey their credit quality to the market, and firms that are more sensitive business to economic cycles are more affected by the procyclical rating policy.