Director Networks and Credit Ratings

Publication Date01 May 2018
AuthorSubramanian Rama Iyer,Kristopher J. Kemper,Jing Zhao,Bradley W. Benson
DOIhttp://doi.org/10.1111/fire.12157
Date01 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.
C2018 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.

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