Do Security Analysts Discipline Credit Rating Agencies?

Abstract

Credit ratings of corporations are biased but the forces driving this bias are unclear. We argue it would be difficult for rating agencies to issue high grades for a firm’s debt when there is lots of objective equity analyst reports about the firm’s earnings which are informative about a firm’s default. We find that an exogenous drop in analyst coverage leads to greater optimism-bias in ratings, especially for firms with little bond analyst coverage and firms that are close to default. This coverage-induced shock leads to less informative ratings about future defaults and downgrades, and more subsequent bond security mispricings.

Keywords: credit rating agencies, rating bias, competition