Structural Shifts in Credit Rating Standards

Abstract

I examine the time-series variation in corporate credit-rating standards (i.e., whether the rating agencies become more generous or stringent in rating assignments) from 1985 to 2007. A divergent pattern exists between investment-grade and speculative-grade rating standards from 1985 to 2002 as investment-grade standards tighten and speculative-grade loosen. In 2002, a structural shift occurs towards more stringent ratings. Holding characteristics constant, firms experience a drop of 1.5 notches in ratings due to tightened standards from 2002 to 2007. Credit-spread tests suggest that the variation in standards is not completely due to changes in the economic climate. Changes in standards appear to affect credit-spreads and default rates. Evidence exists to suggest that loose ratings lead to higher default and lower recovery rates.

Keywords: rating, credit rating, rating inflation, rating conservatism, credit rating standard, Dot-Com crash, Sarbanes-Oxley

JEL Classification: G3, G10, G20, L5