Do Rating Agencies Benefit from Providing Higher Ratings? Evidence from the Consequences of Municipal Bond Ratings Recalibration

• Author: JOSEPH WEBER,ANNE BEATTY,REINING PETACCHI,JACQUELYN GILLETTE
• Date: 01 May 2019
• Published date: 01 May 2019
• DOI: http://doi.org/10.1111/1475-679X.12263

DOI: 10.1111/1475-679X.12263

Journal of Accounting Research

Vol. 57 No. 2 May 2019

Printed in U.S.A.

Do Rating Agencies Benefit from

Providing Higher Ratings? Evidence

from the Consequences of

Municipal Bond Ratings

Recalibration

ANNE BEATTY,

∗JACQUELYN GILLETTE ,†

REINING PETACCHI,

‡AND JOSEPH WEBER

†

Received 1 November 2017; accepted 23 February 2019

ABSTRACT

We ask whether credit rating agencies receive higher fees and gain greater

market share when they provide more favorable ratings. To investigate this

question, we use the 2010 rating scale recalibration by Moody’s and Fitch,

which increased ratings absent any underlying change in issuer credit qual-

ity. Consistent with prior research, we find that the recalibration allowed the

clients of Moody’s and Fitch to receive better ratings and lower yields. We

add to this evidence by showing that the recalibration also led to larger fees

and to increases in the market shares of Moody’s and Fitch. These results are

∗Fisher College of Business, The Ohio State University; †Sloan School of Manage-

ment, Massachusetts Institute of Technology; ‡McDonough School of Business, Georgetown

University.

Accepted by Douglas Skinner. We appreciate helpful comments from an anonymous

referee, Christine Cuny (discussant), Bob Holthausen, Stephen Karolyi (discussant), Chris-

tian Leuz, and workshop participants at the Carnegie Mellon Summer Slam, 2018 FARS

midyear meeting, Harvard, Illinois, 2018 JAR Conference, LSE, LSU, Stanford, SUNY Buf-

falo, Toronto, 2018 Utah Winter Accounting Conference, and William & Mary. An on-

line appendix to this paper can be downloaded at http://research.chicagobooth.edu/

arc/journal-of-accounting-research/online-supplements.

323

CUniversity of Chicago on behalf of the Accounting Research Center,2019

324 A.BEATTY,J.GILLETTE,R.PETACCHI,AND J.WEBER

consistent with critics’ concerns about the effects of the issuer-pay model on

the credit ratings market.

JEL codes: G24; G28; H74; M40; M41

Keywords: credit rating; rating agency; municipal debt; issuer-pay model;

conflicts of interest

1. Introduction

Critics argue that credit rating reliability was reduced when Moody’s and

S&P changed from an investor-pay model to an issuer-pay model in the

early 1970s. Academics, the popular press, and regulators suggest that when

issuers purchase ratings, they will select the ratings agency that provides

them with the most favorable ratings. This “ratings shopping” could prompt

ratings agencies to upwardly bias their ratings in return for larger fees and

market share. Industry supporters counter that the potential reputational

harm from biasing ratings deters ratings agencies from offering higher rat-

ings for larger fees. The recent financial crisis has led to a renewed interest

in this long-standing debate.1We provide new evidence on this controversy

by examining whether municipal debt issuers pay ratings agencies more for

favorable ratings, and whether more favorable ratings lead to increases in

market share.

Existing academic research provides indirect evidence on how the issuer-

pay model affects fees and market share. The general lack of disclosure of

the fees charged makes it difficult to examine whether credit ratings agen-

cies benefit from providing more favorable ratings, and a lack of exogenous

variation in ratings makes it difficult to separate the determinants of rating

fees. We add to this literature by taking advantage of ratings fee disclosures

in certain jurisdictions in the municipal bond market and a recalibration of

the municipal ratings methodology by Moody’s and Fitch. If we can observe

increases in credit ratings and ratings fees not caused by changes in credit

fundamentals, we can test whether increased ratings result in increased fees

and increased market share.2

1For example, the Washington Post’s Steven Pearlstein [2009] argued that ratings agencies

failed as gatekeepers during the recent credit crisis when they were seduced to provide “triple-

A ratings to stuff they barely understood.”

2The recalibration is uncorrelated with changes in credit fundamentals and is also unlikely

to be economically valuable (see section 2). Moody’s Investor Service [2010] Rating Imple-

mentation Guidance states, “This recalibration does not reflect an improvement in credit

quality or a change in our credit opinion for rated municipal debt issuers.” Fitch similarly as-

serts that the recalibration was merely a change to their Global Scale ratings methodology (see

Business Wire [2010]). Cornaggia, Cornaggia, and Israelsen [2018] document a reduction in

yields for recalibrated debt primarily held by retail investors. After a battery of robustness tests

including changes in market demand, liquidity, and issuers’ intrinsic quality, they conclude

that the reduction is driven by investors’ reliance on ratings.

DO RATING AGENCIES BENEFIT FROM PROVIDING HIGHER RATINGS?325

In April 2010, both Moody’s and Fitch recalibrated their ratings on mu-

nicipal debt to increase the comparability of ratings across asset classes.

Before the recalibration, Moody’s and Fitch used a Municipal Rating

Scale, which historically measured default risk (Adelino, Cunha, and

Ferreira [2017], Cornaggia, Cornaggia, and Israelsen [2018]). After the re-

calibration, both Moody’s and Fitch moved to the Global Ratings Scale used

for corporate, sovereign, and structured finance debt, which combines de-

fault risk and expected losses given default. Because of this recalibration,

over a half a million bonds rated by Moody’s and Fitch received improved

credit ratings with no corresponding reduction in default risk. S&P did not

recalibrate their ratings, arguing they did not employ a dual ratings system.3

The difference between a ratings agency with a systematic ratings recalibra-

tion versus one without provides us with a rare opportunity to isolate the

effects of ratings on fees paid and rating agency selection largely free from

confounding factors.

Cornaggia, Cornaggia, and Israelsen [2018] provide an in-depth discus-

sion of how the recalibration affects ratings and bond yields. They find that

Moody’s upward recalibration of over $1.3 trillion of debt led to ratings

increases of one to three notches depending on the debt type and preexist-

ing rating. The recalibration also led to yield decreases compared to bonds

not recalibrated, especially for bonds more likely to be held by unsophisti-

cated (retail) investors and bonds issued by less transparent governmental

entities.4They conclude that investors with limited alternative information

sources mechanically use ratings to price bonds.

We argue that the ratings recalibration is an ideal setting to examine the

effect of ratings upgrades on fees and market share. First, the recalibration

directly affected ratings (which we confirm in our sample) but was unlikely

to directly affect fees (which we discuss more below). Second, the recalibra-

tion appears to have yielded significant reductions in interest costs paid by

issuers. Cornaggia, Cornaggia, and Israelsen [2018] provide a conservative

estimate that municipalities paid an extra $1 billion in interest due to the

lower ratings on the old Municipal Rating Scale. Given the oligopolistic na-

ture of the ratings market, it is possible that the recalibration could lead to

increases in both fees and market share.

Ratings fee data are only available for municipal bonds issued in Texas

and California. The Texas Bond Review Board and the California State

3Cornaggia, Cornaggia, and Hund [2017] quote S&P’s president, Devin Sharma, as stating

that, “We have always had one scale, a consistent scale that we have tried to adopt across all

our asset classes.”

4Cornaggia, Cornaggia, and Israelsen [2018] investigate whether increases in liquidity or

demand for bonds of certain levels of government produce the yield changes. They find a

small, transitory liquidity increase over an initial 90-day window. In their analysis, they include

government-level fixed effects that vary over the pre- and postperiods and find that their “main

results are virtually unchanged” (p. 2061). They conclude that there is no evidence of increases

in demand of the recalibrated bonds.