Time-Varying Rating Standards and The Distorted Incentives of Credit Rating Agencies

Abstract

Credit rating agencies have been widely criticized to issue inflated ratings due to the issuer-pay business model. This thesis analyses the credit rating standards and tests whether reputation concerns are powerful enough to discipline the rating agencies. I argue that due to rating agencies' distorted incentives, credit ratings are more likely to be inflated when corporate bond investors are more risk-averse and the slope of corporate bond credit-yield curve is higher. The empirical study using a large dataset of credit ratings from 1985 to 2011 verifies such hypothesis and suggests that reputation concerns are not always powerful enough to serve as a self-disciplining mechanism. Besides, I find that the sensitivity of credit ratings on the slope of corporate bond credit-yield curve is higher for complex firms as well as risky firms. Such findings provide further evidence for the distorted incentives of credit rating agencies.