The Role of Credit Ratings and Agencies in Coordinating Managerial Behavior: An Empirical Analysis of 1923-2005

Abstract

In this paper we empirically examine the stock price response to credit rating changes, with a particular focus on the credit watch procedure. The credit watch procedure allows for an ongoing monitoring role of the credit rating agency and implicit contracting between the credit rating agency and a firm in the event of a potential change in the firm's credit quality. Most previous empirical work has not conditioned on the presence of a credit watch, and thus may not have accurately measured the true informational content of rating changes. This paper builds on the theoretical work of Boot, Milbourn and Schmeits (2006) which provides a novel rationale for credit ratings and the credit watch procedure. We revisit some of the mixed empirical evidence regarding rating changes and test several new predictions with respect to cross-sectional differences in stock price responses to rating changes, credit watch announcements and the resolution of credit watch procedures, as well as the likelihood that firms are put on credit watch. We furthermore analyze how the introduction of Regulation FD has affected the informational value of credit ratings. An important contribution here is the inclusion of Standard and Poors' credit rating data from 1923-2005. An early result includes the finding that stock prices react more negatively to a downgrade if the firm was on credit watch, suggesting that ratings agencies are in fact bringing new, value-relevant information to market.