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Do Rating Agencies Behave Defensively for Higher Risk Issuers?

By: Samuel B. Bonsall IV, Kevin Koharki, Pepa Kraft, Karl A. Muller III and Anywhere Sikochi
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Abstract

We examine whether rating agencies act defensively toward issuers with a higher likelihood of default. We find that agencies' qualitative soft rating adjustments are more accurate as issuers' default risk grows, as evidenced by the adjustments leading to lower Type I and Type II error rates and better prediction of default and default recovery losses. We also find that soft adjustments' relevance increases with issuers' default risk, as evidenced by the adjustments being more predictive of initial offering yields and leading to a greater market reaction to rating changes. Further, we find that the rating agencies assign better educated and more experienced analysts to higher risk issuers, providing evidence of one mechanism used by the rating agencies to generate more accurate and relevant soft adjustments. Overall, our study suggests that as the likelihood of issuer default grows the threat of reputational harm from discovered rating failures increasingly mitigates the rating agencies' strategic behavior incentivized by the issuer-pay model.

Keywords

Credit Rating Agencies; Soft Rating Adjustments; Default; Credit; Performance Evaluation; Measurement and Metrics; Financial Institutions; Risk Management

Citation

Bonsall, Samuel B., IV, Kevin Koharki, Pepa Kraft, Karl A. Muller III, and Anywhere Sikochi. "Do Rating Agencies Behave Defensively for Higher Risk Issuers?" Management Science (forthcoming). (Pre-published online September 15, 2022.)
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About The Author

Anywhere Sikochi

Accounting and Management
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  • Harambe: Mobilizing Capital in Africa By: Anywhere Sikochi
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  • Performance Management at Afreximbank (A) and (B) By: Robert S. Kaplan and Siko Sikochi
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