Director Networks and Credit Ratings

• Published date: 01 May 2018
• DOI: http://doi.org/10.1111/fire.12157
• Date: 01 May 2018

The Financial Review 53 (2018) 301–336

Director Networks and Credit Ratings

Bradley W. Benson

Ball State University

Subramanian Rama Iyer∗

University of New Mexico

Kristopher J. Kemper

Ball State University

Jing Zhao

Portland State University

Abstract

We explore the effect of director social capital, directors with large and influential net-

works, on credit ratings. Using a sample of 11,172 firm-year observations from 1999 to 2011,

we find that larger board networks are associated with higher credit ratings than both firm

financial data and probabilities of default predict. Near-investment grade firms improve their

forward-looking ratings when their board is more connected. Last, we find that larger director

networks are more beneficial during recessions, and times of increased financial uncertainty.

Our results are robust to controls for endogeneity. Tests confirm that causality runs from

connected boards to credit ratings.

∗Corresponding author: FITE Department, Anderson School of Management, Universityof New Mexico,

Albuquerque, NM 87131; Phone: (505) 277-3207; E-mail: sriyer@unm.edu.

We benefited by comments from an anonymous referee, the Editor Srinivasan Krishnamurthy, Greg

Nagel, Hong Qian, and Xiaoxin Wang Beardsley. We thank the University of New Mexico Center for

Advanced Research Computing for computational resources. We are grateful to Steve Koch of Epic

Software for the software codes. We welcomed comments from conference participants at the Eastern

Finance Association 2017, Southwestern Finance Association 2017, and Southern Finance Association

2016. Jing Zhao gratefully acknowledges financial support from The Cameron Research Fellowship in

Finance at School of Business Administration, Portland State University.

C2018 The Eastern Finance Association 301

302 B. W. Benson et al./The Financial Review 53 (2018) 301–336

Keywords: director networks, social capital, credit ratings, board connectivity

JEL Classifications: G24, G32

1. Introduction

Credit rating agencies (CRAs) attempt to correctly predict default risk and assign

accurate ratings in the presence of asymmetric information between management and

the rating agency. One tool that CRAs use to close this information gap is the quality

and qualifications of top management and the board of directors of the firm they are

rating. For example, Frost (2007) shows that CRAs rely on qualitative information

when assessing credit ratings. Huang, Chen, Hsu, Chen and Wu (2004) show that

purely financial empirical models do not fully capture firm ratings due to the sub-

jective nature of the rating process. Similarly,Odders-White and Ready (2006) show

that a rating contains information that is not fully depicted in a firm’s financials. For

instance, Khatami, Marchica and Mura (2016), find that direct personal connections

between directors and CRAs result in higher credit ratings than fundamentals suggest.

They reveal that CRAs rely on these connections to reduce information asymmetry,

resulting in a more favorable credit rating.

We extend Khatami, Marchica and Mura (2016), who focus on direct connec-

tions between CRAs and directors (direct information channel), by examining the

role of each director’s overall network (indirect reputation channel or trust channel)

in the credit rating decision. We argue that this reputation channel also provides im-

portant information about the quality of the board of directors, based on the size and

characteristics of the director’s network. Our research builds on the concept of social

capital (Putnam, 1995; Rothstein, 2000), or that the number and importance of one’s

social connections influence the perceived trustworthiness and reputation. Belliveau,

O’Reilly and Wade (1996, p. 1568) define social capital as “an individual’s personal

network.” Paldam (2000) argues that the deepest definition of social capital deals

with trust. The foundation of that trust is the perceived reputation that everyone will

do his or her part, behave well and adhere to a sense of duty.We predict that directors

with larger and more influential networks have greater social capital. This reduces

information asymmetry between the CRA and the firm, leading to a higher credit

rating. Lu, Chen and Liao (2010) find that investors demand higher credit spreads

under conditions of information asymmetry and information uncertainty. Conversely,

research supports the concept of connections increasing information flow and re-

ducing information asymmetry (Fracassi, 2008; Cohen, Frazzini and Malloy, 2010;

Renneboog and Zhao, 2011, 2014; Cust´

odio and Metzger, 2013; Ishii and Xuan,

2014; Omer, Shelley and Tice, 2014).

Directors with larger networks are better monitors and advisors due to their in-

formation and professional advantage (Coles, Wang and Zhu, 2015). Boards with

B. W. Benson et al./The Financial Review 53 (2018) 301–336 303

larger networks have been shown to make better decisions regarding CEO re-

placement and appointment (Coles, Wang and Zhu, 2015), acquisitions (Schonlau

and Singh, 2009), and improve firm performance (Geletkanycz and Boyd, 2011;

Larcker, So and Wang, 2013). Engelberg, Gao and Parsons (2012) also find that con-

nected boards provide economic value and lower the interest rates charged by banks.

Chuluun, Prevost and Puthenpurackal (2014) find that better-connected boards lead

to lower spreads. Javakhadze, Ferris and French (2016a) show that greater social

capital improves financial development by reducing the impediments to external fi-

nancing. Javakhadze, Ferris and French (2016b) find that direct connections between

directors, senior management, and financiers reduce financial constraints and sensi-

tivity of external financing to cash flow. Larger director networks also arise because

a director has greater talent, expertise, and experience. All of this suggests that con-

nected directors improve monitoring, reduce wasteful spending, and conserve cash.

This benefits bondholders and improves the credit rating of the firm. Well-connected

directors also indirectly certify the quality of the firm. CRAs can incorporate this

certification when making rating decisions.

An alternative view states that larger director networks are associated with

lower credit ratings. Directors with larger networks are more likely to be busy di-

rectors, making them worse monitors or advisors (Fich and Shivdasani, 2006). The

reason for this is because of time constraints, event conflicts, and directors’ effort

constraints (Ferris, Jagannathan and Pritchard, 2003). For instance, busy boards are

associated with poor firm performance (Fich and Shivdasani, 2006; Jiraporn, Kim

and Davidson, 2008; Ahn, Jiraporn and Kim, 2010; Andres, Bongard and Lehmann,

2013). Research also finds that busy boards have low board meeting attendance

(Jiraporn, Davidson, DaDalt and Ning, 2009), a greater likelihood of financial state-

ment fraud (Beasley, 1996), and weaker corporate governance(Fich and Shivdasani,

2006; Andres, Bongard and Lehmann, 2013). Thus, well-connected boards can re-

duce monitoring by increasing board busyness. This can lead to lower credit ratings

assigned by CRAs.

Our results are more consistent with a reputational and monitoring effect of

director networks. Using a sample of 11,172 firm-year observations from 1999 to

2011, we find that larger board networks are associated with higher credit ratings than

predicted by both firm financial data and probabilities of default.The effect of director

networks is greater in firms just below investmentrating. Near-investment grade firms

improve their forward-looking ratings when their board is more connected. Last, we

find that better connected boards are more beneficial during recessions, and times

of increased financial uncertainty. Our results are robust to controls for endogeneity.

Our tests confirm that causality runs from connected boards to credit ratings.

We contribute to the literature in several ways. First, we demonstrate that the

size and relative importance of a board’s network and its social capital, influences

credit ratings. While other disciplines explore the concept of social capital, including

economics, sociology and management (Adler and Kwon, 2002), we are the first to

argue that social capital influences credit ratings.