Ratings Quality and Borrowing Choice

47 Pages Posted: 17 May 2016

See all articles by Dominique C. Badoer

Dominique C. Badoer

University of Illinois at Chicago - Department of Finance

Cem Demiroglu

Koc University, College of Administrative Sciences and Economics

Christopher M. James

University of Florida - Department of Finance, Insurance and Real Estate

Date Written: May 12, 2016

Abstract

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

Suggested Citation

Badoer, Dominique C. and Demiroglu, Cem and James, Christopher M., Ratings Quality and Borrowing Choice (May 12, 2016). Available at SSRN: https://ssrn.com/abstract=2780485

Dominique C. Badoer (Contact Author)

University of Illinois at Chicago - Department of Finance ( email )

2431 University Hall (UH)
601 S. Morgan Street
Chicago, IL 60607-7124
United States

Cem Demiroglu

Koc University, College of Administrative Sciences and Economics ( email )

Koc University
Sariyer
Istanbul, 34450
Turkey
90-212-338-1620 (Phone)
90-212-338-1653 (Fax)

HOME PAGE: http://https://sites.google.com/site/cemdemiroglu/

Christopher M. James

University of Florida - Department of Finance, Insurance and Real Estate ( email )

P.O. Box 117168
Gainesville, FL 32611-7168
United States
352-392-3486 (Phone)
352-392-0301 (Fax)

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