Financial Reporting and Credit Ratings: On the Effects of Competition in the Rating Industry and Rating Agencies' Gatekeeper Role

• Published date: 01 May 2019
• Author: STEFAN F. SCHANTL,KYUNGHA (KARI) LEE
• DOI: http://doi.org/10.1111/1475-679X.12264
• Date: 01 May 2019

DOI: 10.1111/1475-679X.12264

Journal of Accounting Research

Vol. 57 No. 2 May 2019

Printed in U.S.A.

Financial Reporting and Credit

Ratings: On the Effects

of Competition in the Rating

Industry and Rating Agencies’

Gatekeeper Role

KYUNGHA (KARI) LEE

∗AND STEFAN F. SCHANTL †

Received 25 September 2017; accepted 6 March 2019

Abstract

This paper studies firms’ financial reporting incentives in the presence of

strategic credit rating agencies and how these incentives are affected by the

level of competition in the rating industry and by rating agencies’ role as

gatekeepers to debt markets. We develop a model featuring an entrepreneur

who seeks project financing from a perfectly competitive debt market. After

publicly disclosing a financial report, the entrepreneur can purchase credit

ratings from rating agencies that strategically choose their rating fees and

rating inflation. We derive the following core results: (1) More rating indus-

try competition leads to stronger corporate misreporting incentives if ratings

∗Rutgers, The State University of New Jersey †Department of Accounting, The University

of Melbourne.

Accepted by Haresh Sapra. We appreciate the helpful comments and suggestions from

an anonymous referee, Tim Baldenius, Jannis Bischof, Thomas Bourveau, Hui Chen, Edwige

Cheynel, Ron Dye, Jonathan Glover, Suresh Govindaraj, Moritz Hiemann, Kenji Matsui, Matt

Pinnuck, Ulf Schiller,Jordan Schoenfeld, Naomi Soderstrom, Jeroen Suijs, and Alfred Wagen-

hofer, as well as from workshop and conference participants at Columbia University, Hong

Kong University of Science and Technology, Rutgers University, University of Basel, Univer-

sity of Graz, University of Mannheim, University of Melbourne, University of Z¨

urich, the 2016

EIASM Workshop of Accounting and Economics in Tilburg, the 2017 FARS Midyear Meeting

in Charlotte, and the 53rd Annual (2018) Journal of Accounting Research Conference.

545

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

546 K.LEE AND S.F.SCHANTL

are sufficiently precise or if rating agencies assume a gatekeeper role. Un-

der imperfect rating industry competition, (2) agencies’ gatekeeper role pri-

marily weakens firms’ misreporting incentives, which then influences rating

agencies’ strategies, and (3) firms’ misreporting and rating agencies’ rating

inflation can be strategic complements when agencies assume a gatekeeper

role. (4) Regulatory initiatives aimed at increasing rating industry competi-

tion or at weakening rating agencies’ gatekeeper role improve investment

efficiency as long as corporate misreporting incentives are not significantly

strengthened.

JEL codes: D80; G12; G24; G28; M41

Keywords: corporate disclosure; credit rating; rating inflation; investor reg-

ulation; competition

1. Introduction

Credit ratings play a key role in firms’ debt financing, and evidence shows

that more favorable ratings lead to a lower cost of debt (Kliger and Sarig

[2000], Graham and Harvey [2001], Tang [2009]). Given the well-known

links between financing, investing, and reporting, firms’ reporting incen-

tives may therefore crucially depend on their credit ratings. The joint ev-

idence of several archival papers comports with the argument that firms

distort their financial reports more before an initial rating or a credit rat-

ing change (Jiang [2008], Alissa et al. [2013], Jung, Soderstrom, and Yang

[2013]). These papers interpret their findings as firms using financial re-

porting to influence credit ratings. However, evidence by Kraft [2015] indi-

cates that credit rating agencies (CRAs) exhibit superior information pro-

cessing abilities and may not be easily misled by firms’ misreporting when

extracting risk-related information from financial statements. The aim of

this paper is to reconcile these two arguments and illuminate the possibly

endogenous relationship between financial reporting and credit ratings by

explicitly considering some of the unique features of the rating process and

CRAs’ strategic incentives.

Like most other businesses, CRAs’ main objective is to generate income.

They do so by selling credit ratings to debt-issuing firms in exchange for

a fee they strategically choose. CRAs face a conflict of interest between

providing informative ratings to investors and catering to issuers’ prefer-

ence for favorable ratings. This conflict arises either because firms can pri-

vately observe the rating before making their purchase decision such that

they can be selective (a practice commonly referred to as “ratings shop-

ping”) or through repeated interactions between CRAs and issuers. As a

consequence, CRAs may have incentives to inflate their ratings to boost

fee income (Skreta and Veldkamp [2009], Bolton, Freixas, and Shapiro

[2012], Sangiorgi and Spatt [2017]). Regulators and scholars in finance

and law have further highlighted the importance of two other critical

factors that influence CRAs’ decisions. First, competition in the rating

FINANCIAL REPORTING AND CREDIT RATINGS 547

industry shapes CRAs’ incentives, as it affects their ability to extract rents

from issuers through fees (Lizzeri [1999]). Second, credit ratings were used

to regulate certain institutional investors by requiring them to only invest in

firms with investment-grade ratings. Furthermore, retirement funds often

commit to investing only in investment-grade debt (Kisgen and Strahan

[2010]). This regulatory or self-imposed reliance on credit ratings, estab-

lishing the gatekeeper role of CRAs to debt markets (Partnoy [1999, 2006]),

has been implicated as one of the main sources of rating inflation leading

up to the 2008 Global Financial Crisis.

In this paper, we study firms’ financial reporting incentives in the pres-

ence of strategic CRAs and how these incentives are affected by the level

of competition in the rating industry and CRAs’ gatekeeper role. We de-

velop a model featuring three types of players: a firm represented by an en-

trepreneur (“she”), who seeks debt financing to undertake a risky project;

a debt market populated by investors, who competitively set interest rates;

and one or two CRAs, which aim to sell credit ratings to the entrepreneur.

Initially, the entrepreneur privately observes a signal about her firm’s type,

where the firm type codetermines the project’s outcome, and must issue a

financial report that need not truthfully disclose her private information.

After disclosure of the financial report, CRAs strategically set their fees.

Each CRA then privately observes an imperfect signal about the project

outcome and develops a rating that may be distorted through rating infla-

tion. Each CRA privately submits its rating to the entrepreneur, who then

decides on whether to purchase the rating. If purchased, the rating is made

public. Investors determine the interest rate after observing the financial

report and the purchased ratings.

We derive a number of novel insights. First, we establish that, absent

CRAs’ gatekeeper role, increases in the intensity of competition in the

rating industry can strengthen or weaken firms’ misreporting incentives,

depending on the information quality of credit ratings. Corporate misre-

porting incentives are determined by the rent that the entrepreneur ex-

pects to receive from pursuing the project, net of the expected debt repay-

ment (where interest rates are chosen by investors) and rating fees (which

are chosen by CRAs). A larger expected rent implies stronger misreport-

ing incentives. The interest rates investors choose are influenced by both

the firm’s financial report and CRAs’ credit ratings. In equilibrium, the

entrepreneur only purchases favorable ratings, as only these lead to lower

interest rates. We show that a monopolistic CRA chooses its rating fee such

that it extracts the entire expected rent that is generated from providing

a favorable rating, leaving the entrepreneur with a relatively low rent. In

contrast, with imperfect competition between multiple strategic CRAs, the

ability of CRAs to extract rents is constrained, and they are forced to lower

their fees. This leaves the entrepreneur with a larger expected rent, as

she retains a part of the value that is created by favorable ratings, incen-

tivizing her to misreport more. However, a countervailing force is present

through investor price protection. Rational investors conjecture that the