Qualitative Corporate Disclosure and Credit Analysts' Soft Rating Adjustments

Abstract

While academics have extensively studied quantitative models of credit risk, far less is known about credit analysts’ behind-the-scenes adjustments to the ratings generated by their models. Using both dictionary-based and topic modeling approaches, we examine whether and how credit analysts use borrowers’ qualitative disclosures to extract information pertaining to credit risk in making their assessments. We decompose publicly-available ratings into qualitative factors (soft adjustments) and quantitative factors (hard adjustments) and find that credit analysts’ soft adjustments, but not the hard adjustments, reflect information in borrowers’ qualitative disclosures. Our results further indicate that the association between firms’ qualitative disclosures and soft adjustments increases with the intensity of the rating agency’s reliance on public disclosure. We also examine whether analysts’ use of credit risk-relevant information from borrowers’ qualitative disclosures render ratings more credible and thus informative. We find that the credit rating downgrades of borrowers that provide more qualitative disclosures are more informative than those that do not; however, the increase in informativeness diminishes after the Dodd-Frank Act, when the legal liability for credit rating agencies increased.