The Disciplinary Role of CDS Markets: Evidence from Agency Ratings

Abstract

Since the beginning of the financial crisis there have been various attempts to correct weaknesses within the rating process. Most of these initiatives aim at incentivizing rating agencies by increasing regulatory pressure. We argue that there is another way to discipline agencies: the credit default swap (CDS) market. Based on a sample of more than 4,000 corporate bond issues, we show that purely the existence of an external CDS benchmark leads to an increased level of rating quality. In particular, we show that ratings monitored by an actively traded CDS are more strongly correlated with bond spreads at issuance, timelier adjusted when credit-worthiness changes, better predictors of defaults, and less volatile. Moreover, we provide evidence that the observed quality improvements are most likely driven by reduced incentive conflicts stemming from increased reputational concerns.