Use Of Credit Ratings Research Articles

The Use of Credit Ratings in the Delegated Management of Fixed Income Assets

Investment mandates of fixed income funds constrain managers’ portfolio decisions, often employing credit ratings to classify asset risk. We categorize U.S. and European fixed income funds’ mandates using textual analysis and measure the use of ratings. Over the past two decades, despite the weaknesses of ratings revealed in the global financial crisis, ratings use has increased significantly. Since 2010, the fraction of funds not using ratings in any way has fallen by almost half in both the United States and Europe. By 2020, 94% of U.S. funds and 65% of European funds used ratings. These patterns fit agency-based models of investment mandates and point to a lack of practically useful alternatives. This paper was accepted by Tomasz Piskorski, finance. Funding: This work was supported by the Nasdaq Nordic Foundation. Supplemental Material: The data files and e-companion are available at https://doi.org/10.1287/mnsc.2023.4848 .

Rethinking the Use of Credit Ratings in Capital Regulations: Evidence From the Insurance Industry

Abstract We analyze an initiative by insurance regulators to reform capital regulations for mortgage-backed securities (MBS) by replacing credit ratings with third-party estimates of expected credit losses and by considering an insurer’s exposure to future losses when determining regulatory capital. After implementation, insurers are less likely to sell distressed MBS, gains trade corporate bonds, and/or raise external financing. However, the new regime allows insurers to purchase more low-rated MBS at significant capital savings and insurers with greater capital savings are more likely to do so. Our analysis highlights the potential costs and benefits of an alternative methodology for determining regulatory capital. JEL (G11, G18, G22, G28, G32, G38). Received May 6, 2019; editorial decision April 4, 2020 by Editor Andrew Ellul.

The Private Use of Credit Ratings: Evidence from Investment Mandates

Fixed income markets rely on delegated asset management, where fund managers’ portfolio decisions are directed and restricted by investment mandates. We use textual analysis to classify U.S. fixed income funds’ mandate contents. Credit ratings can be used in mandates to define investable assets. Despite the shortcomings of ratings revealed in the global financial crisis, their use in mandates has steadily increased over the past two decades. By 2018, ratings are used by 94% of fixed income mutual funds. Credit ratings are an integral feature of contracting in financial markets and our results point to a lack of practically useful alternatives.

Wykorzystanie ratingów kredytowych do celów regulacyjnych w Unii Europejskiej

The aim of the article is to demonstrate the use of credit ratings for regulatory purposes in the EU. In principle, they increase competition on the EU market of rating services. For this purpose all EU institutions should automatically accept the ratings issued by credit rating agencies registered by European Securities and Markets Authority. Unfortunately, the Eurosystem does not accept this principle. Its actions discriminate small credit rating agencies and consolidate oligopolistic market structure.

Asymmetry in Empowering and Disempowering Private Intermediaries

This article analyzes the empowerment and disempowerment of credit rating agencies (CRAs) as private regulatory intermediaries. Until the recent financial crisis, regulators heavily relied on private credit ratings to impose risk-sensitive requirements on financial market actors (targets). Regulatory use of credit ratings was instrumental in empowering CRAs because regulatory authority was delegated to them and their own private power was bolstered by public endorsement. But regulators’ subsequent efforts to disempower the CRAs—more recently regarded as dysfunctional “runaway” intermediaries—have proven costly, complicated to do, and hardly consequential in limiting CRAs’ de facto power. This dynamic reveals a path-dependent power shift in favor of private intermediaries that is more pronounced (1) the larger the intermediary’s own sources of power when an RIT arrangement is established, (2) the larger the transfer of authority to the intermediary, and (3) the longer regulators rely on the intermediary.

Information Sharing and Rating Manipulation

We show that banks manipulate the credit ratings of their borrowers before being compelled to share them with competing banks. Using a unique feature on the timing of information disclosure of the Argentinean public credit registry, we disentangle the effect of manipulation from learning of credit ratings. We show that banks downgrade high quality borrowers on which they have positive private information to protect their informational rents. Banks also upgrade low quality borrowers to avoid creditor runs. Our results can explain the limited effectiveness of public credit registries and cast doubt on the use of credit ratings in reducing information asymmetry.

Exploring rating shopping for european triple a senior structured finance securities

In much of the research with respect to the use of credit ratings, the notion of rating shopping features prominently. One form of rating shopping predicts that investors price the risk that arises when securities have fewer than three ratings. Inconsistent with what rating shopping would predict, our study shows that for the largest European structured finance market, the triple A sector of the senior European residential mortgage-backed market prior to 2007, investors demanded a premium for more ratings. Moreover, we find that certain characteristics unique to structured finance securities that investors perceive as complex, determine whether issuers opt for a higher number of triple A ratings.

A CRITICAL ANALYSIS OF THE RECENT RUSSIAN REGULATION ON CREDIT RATING AGENCIES

Since the recent financial crisis of 2008, credit rating agencies (CRAs) have been under scrutiny for their role in the proliferation of structured finance products. Whether their methodological tools and evaluations have been up to standard is in question. As is well-known, CRAs are multinational enterprises that operate on a global basis. Their evaluations may well hinder the stability of international markets. As a legal response to the many concerns raised about CRAs, different approaches have been applied to the use of credit ratings in the US and EU with many similarities. In this international scenario, the government of the Russian Federation also recently introduced a new regulation on CRAs, drafted on the lines of the European regulation. This short paper is targeted to inform the reader of certain aspects of the newly approved regulation in Russia and to examine – in a comparative way – whether the introduced rules match the expectations behind the initiatives of the Russian government.

Do Multiple Credit Ratings Signal Complexity? Evidence from the European Triple-A Structured Finance Securities

In much of the current research on market practices with respect to the use of credit ratings, the rating shopping hypothesis and the information production hypothesis feature prominently. Both of these hypotheses predict an inverse relationship between the number of ratings and a security’s funding cost; that is, more ratings will reduce funding costs and, conversely, fewer ratings will increase funding costs. Our study finds precisely the opposite to have been the case for the mainstay of the structured finance securities market in Europe prior to 2007, namely the triple-A tranches of European residential mortgage-backed securities. Our findings suggest that structured finance markets may behave differently than what would be predicted by two hypotheses traditionally used to explain the number of ratings and funding costs: the rating shopping and information production hypotheses. Obtaining multiple credit ratings may be a signal for complexity, for which investors demand a risk premium.

The Risk of Ratings in Bank Capital Regulation

The article analyses the rationale of credit ratings in financial market regulation with a specific focus on bank capital regulation. Specifically, it traces the development of external credit ratings in bank capital regulation and in particular how they became a major component of Basel II. In doing so, it reviews how ratings were used in the structured finance markets before the global financial crisis began in 2007 and how their misuse contributed to the crisis. Because ratings had become an integrated feature in banking and securities market regulation, risk management in financial firms became excessively dependent on their use thereby creating agency problems and increased systemic risks in financial markets. The paper also considers the implications of the use of credit ratings in bank capital regulation for macro-prudential supervision and the control of systemic risks. It highlights the different approaches to the use of credit ratings in bank capital regulation between the European Union and the United States and suggests that the lack of harmonisation in this area could lead to market distortions and systemic risks. Finally the article concludes that credit ratings are inappropriate in prudential bank regulation especially in determining bank regulatory capital and their use should be reconsidered in the Basel III agreement.

The Removal of Credit Ratings from Capital Regulation: Implications for Systemic Risk

We analyze an initiative by insurance regulators to rethink the use of credit ratings in assessing capital adequacy. The new regulations replace ratings with potentially more precise third-party estimates of expected credit losses and take into consideration an insurer's current exposure to such losses when determining the appropriate capital charge. This change alleviates the need for insurers to rebalance their portfolios or raise equity to repair regulatory capital. After the change, insurers are less likely to sell distressed MBS, gains trade corporate bonds, or raise external financing. However, the new regime allows insurers to purchase more low-rated MBS at significant capital savings. Our analysis highlights some of the tradeoffs financial agencies should consider when implementing the Dodd-Frank mandate to remove credit ratings in financial regulations.

Regulating Credit Ratings Agencies: Where to Now?

This paper reviews current proposals to regulate credit rating agencies. The proposals can be classified in two broad areas: (1) micro- and (2) macro-prudential measures. While the previous regulations relied on micro-prudential measures, experience from the U.S. subprime crisis and the European sovereign debt crisis shows that such an approach did not address the negative externalities from credit ratings, prompting the need to expand the regulatory perimeter. This paper highlights two types of macro-prudential regulation: (i) those that attempt to take credit ratings out of regulation such as Section 939A of the 2010 Dodd-Frank Act and (ii) those that aim to reduce the importance of credit ratings in regulation such as the recent changes to the ECB collateral rules. This paper argues, however, that it remains important that policymakers conduct formal assessments of the impact of the use of credit ratings on financial markets. This can be done through stress tests of institutions that would be affected by rating downgrades. Additional capital requirements and/or liquidity buffers could be used if necessary to mitigate the systemic risk of credit ratings.

Are Credit Ratings Trustworthy? Empirical Study on the Dependence of Corporate Defaults to Market Risk within Investment Grade and Speculative Grade Range

The use of credit ratings has been advocated by regulators in the US as well as in Europe. The creation of “Nationally Recognized Statistical Rating Organizations” statue strengthened the appearance of the triopoly of Moody’s, Standard & Poor’s and Fitch thus creating a de jure dominant position in the markets. The Basel Accords forced many investors to rely on those three agencies throughout the rules on net capital requirements and the “External Credit Assessment Institutions” statue to be nationally implemented. We discuss in this paper the gap between what credit ratings are i.e. subjective credit opinions, and how regulators use them as an accurate assessment of a probability of default of an issuer. We bring evidence that despite all the shortcomings that credit ratings encounter, they still exhibit high performances in ranking the creditworthiness of corporate issuers. If we test empirical corporate defaults against market risk, it appears that speculative grade corporate defaults are 1.5 to 25.9 times more dependent upon the market than investment grade corporate defaults. Otherwise, the strong correlation existing between defaults of speculative grade companies and market indices proves that even if credit fundamentals are correctly rated, companies will always stay exposed to market and systematic risk.

The Impact of the Contractual Use of Ratings on the Rating Process - Evidence from Rating Agency Adjustments

I study the use of credit ratings in debt contracts. When debt contracts use credit ratings rather than accounting ratios to enforce restrictions on borrowers, there is likely to be increased pressure on rating agencies to cater to borrower incentives. I investigate whether the explicit use of ratings in contracts affects rating agencies' incentives to issue more favorable credit risk assessments than justified by the underlying economics. I focus on performance pricing (PP) agreements which are now widespread in lending agreements and which use either ratings or accounting ratios to calibrate pricing grids. I examine whether, ceteris paribus, rating agencies are more likely to cater to borrowers when PP agreements use ratings rather than accounting ratios to administer PP agreements so that rating changes directly impact borrowers' cash flows. I use data from Moody's to investigate this prediction and report evidence from a number of tests that is consistent with the catering hypothesis.

The Credit Rating Crisis

Since June 2007, the creditworthiness of structured finance products has deteriorated rapidly. The number of downgrades in November 2007 alone exceeded 2,000 and many downgrades were severe, with 500 tranches downgraded more than 10 notches. Massive downgrades continued in 2008. More than 11,000 of the downgrades affected securities that were rated AAA. This paper studies the credit rating crisis of 2007-2008 and in particular describes the collapse of the credit ratings of ABS CDOs. Using data on ABS CDOs we provide suggestive evidence that ratings shopping may have played a role in the current crisis. We find that tranches rated solely by one agency, and by S&P in particular, were more likely to be downgraded by January 2008. Further, tranches rated solely by one agency are more likely to suffer more severe downgrades.(This abstract was borrowed from another version of this item.)

The regulatory use of credit ratings in bank capital requirement regulations

The paper addresses recent developments in international bank capital requirement regulations. A major change over the last decade has been the involvement of credit rating agencies in the measurement of bank capital requirements in the Basel II Accord. The proposed way of proceeding is expected to incentivise banks to improve their risk management practices. The authors argue, however, that the ratings-based regulation has negative effects on the financial markets. The paper analyses its effects on the credit rating industry as well as on the banking business. It is recommended that regulators reconsider the use of credit ratings in financial market regulation.

The Use of Credit Ratings in Investment Management in the U.S. and Europe

We analyse a survey of 200 plan sponsors and investment managers in the US and Europe regarding the use of credit rating guidelines in the conduct of their investment activities. We find that ratings-based guidelines are widespread, but their forms and motivations vary considerably. The usage of ratings appears remarkably similar in the US and Europe. The adoption of ratings-based investment guidelines appears driven by the private sector, with regulation playing a relatively minor role. Guidelines generally reference ratings of specific agencies, rather than the ratings of all officially “recognized” agencies. Ratings-based guidelines seem unlikely to destabilize markets because although asset retention guidelines are common, rapid forced selling upon downgrades is not. Market participants express a preference on the margin for more accuracy over more stability, but stability is valued and guidelines rarely include agency outlook designations, which could be used to increase rating accuracy. These findings generally support the hypothesis presented in Cantor [2004] that ratings are used as governance tools by market participants to ameliorate principal-agent problems between asset managers and their clients. <b>TOPICS:</b>Legal and regulatory issues for structured finance, credit risk management, developed

The Use of Credit Ratings in Investment Management in the US and Europe

We analyse a survey of 200 plan sponsors and investment managers in the US and Europe regarding the use of credit rating guidelines in the conduct of their investment activities. We find that ratings-based guidelines are widespread, but their forms and motivations vary considerably. The usage of ratings appears remarkably similar in the US and Europe. The adoption of ratings-based investment guidelines appears driven by the private sector, with regulation playing a relatively minor role. Guidelines generally reference ratings of specific agencies, rather than the ratings of all officially recognized agencies. Ratings-based guidelines seem unlikely to destabilize markets because although asset retention guidelines are common, rapid forced selling upon downgrades is not. Market participants express a preference on the margin for more accuracy over more stability, but stability is valued and guidelines rarely include agency outlook designations, which could be used to increase rating accuracy. These findings generally support the hypothesis presented in Cantor (2004) that ratings are used as governance tools by market participants to ameliorate principal-agent problems between asset managers and their clients.

A Critique on the Proposed Use of External Sovereign Credit Ratings in Basel II

This paper deals with the proposed use of sovereign credit ratings in the Accord on Capital Adequacy (Basel II) and considers its potential effect on emerging markets financing. It investigates in a first attempt the consequences of the planned revisions on the two central aspects of international bank credit flows: the impact on capital costs and the volatility of credit supply across the risk spectrum of borrowers. The empirical findings cast doubt on the usefulness of credit ratings in determining commercial banks' capital adequacy ratios since the standardized approach to credit risk would lead to more divergence rather than convergence between investment-grade and speculative-grade borrowers. This conclusion is based on the lateness and cyclical determination of credit rating agencies' sovereign risk assessments and the continuing incentives for short-term rather than long-term interbank lending ingrained in the proposed Basel II framework.

Credit agency regulation and the impact of credit ratings in the international bond market

The use of credit ratings in financial and other legal documents — both in the USA and Europe —, has led to a situation in which the major rating agencies have become (largely unwilling) participants in the legislative process. This situation has become partly formalized in the US (and is being repeated elsewhere in the European Union, Eastern Europe and Latin America) through the creation of officially ‘recognized’ agencies whose ratings now carry the imprimatur of the Securities and Exchange Commission. The purpose of this paper is to contribute to the debate on the necessity for formal legal status to be sustained in the market for bond credit ratings. In this context, the criteria for a credible rating agency are examined and evidence is provided on one element of the criteria which is under-researched: namely, the impact of the ratings in the market place. The influence of rating agencies in international capital markets is assessed through an analysis of the impact of ratings on the yields of bonds, represented by a comprehensive sample of actively traded debt. The sample contains analysis of ratings introductions on both new and seasoned debt and also examines the impact of ratings revisions. It is concluded that official recognition has no market-based role and it is argued that ratings are used by regulators because of the success of the major agencies in performing their market function.