Subjective or Objective? Nonparametric Estimation of Misreporting and Mis-Assessment in Corporate Credit Rating

Abstract

This paper investigates the misreporting and mis-assessment of corporate credit ratings by credit rating agencies (CRAs). We distinguish between mis-assessment, which is the noise from the unobservable true rating to the rating perceived by CRAs (the internal rating), and misreporting, which is the difference between perceived and reported rating by CRAs. Using a sample of corporate credit ratings during 1986-2011, we find that the mis-assessment in credit rating is very small and statistically insignificant. Also, there is a U-shaped relationship between true credit rating and misreporting probability. Specifically, CRAs misreport the credit ratings for high-grade firms with a probability of 3%, for middle-grade firms with a probability of 0, and for low-grade firms with a probability of 6%. Second, the misreporting behavior of CRAs differ significantly across the industries. The financial industry has the highest misreporting probability (35% in the lowest-grade firms) and the largest misreporting magnitude (rating grade jump between true and reported grade). The energy industry has the lowest misreporting probability. Last, when the economic condition is good, CRAs are more likely to inflate the rating and the inflation magnitude is larger.