An Empirical Analysis of the Effects of the Dodd-Frank Act on Determinants of Credit Ratings

Abstract

We study the effects of the Dodd-Frank Act (“Dodd-Frank”) on determinants of credit ratings. We predict that the increase in regulatory oversight and litigation risk prompted by Dodd-Frank, as well as requirements for improved disclosures and governance, motivated credit rating agencies (CRAs) to increase the weight on firm-specific, quantitative fundamental information in making rating decisions. We find that CRAs place a higher weight on firm-specific fundamentals in determining ratings, and the power of the fundamentals in explaining credit rating variation increases significantly after the passage of Dodd-Frank. Additionally, we find that the greater reliance on firm fundamentals at least partially drives the improvement in credit ratings’ ability to predict future defaults. Finally, we show that Dodd-Frank has an incremental effect beyond the financial crisis on the determinants of credit ratings. Our results are robust to a battery of sensitivity analyses. Collectively, our evidence suggests that Dodd-Frank incentivizes CRAs to use more quantitative information in making rating decisions, which in turn helps improve credit rating quality.

Keywords: Dodd-Frank Act; Fundamental information; Credit rating; Default prediction

JEL Classification: G380; K220; M400