Ratings Quality and Borrowing Choice
47 Pages Posted: 17 May 2016
Date Written: May 12, 2016
This paper examines how the quality of issuer-paid credit ratings affects the choice between “arm’s length” vs. intermediated debt. We argue that investors are more likely to question the quality of issuer-paid ratings when those ratings are more favorable than investor-paid ratings or market-based indicators of credit quality (e.g., CDS spreads). Concerns about the quality of issuer-paid ratings, increase information asymmetries between issuers and investors, resulting in a higher cost of funding. Consistent with this argument, we find that bond spreads are inversely related to our measures of ratings quality, with ratings quality having the greatest impact where the incentives to inflate ratings are the greatest. Additionally, we find that firms with poor quality ratings substitute bank loans for public debt. Overall, our results suggest that poor quality issuer-paid credit ratings are associated with a “lemons discount” that debt issuers attempt to avoid by borrowing from better-informed private lenders.
Keywords: credit ratings, split ratings, conflicts of interest, lemons problem, financial intermediation
JEL Classification: G14, G24, G32
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