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Estimating Unobserved Soft Adjustment in Credit Rating Models: Before and after the Dodd–Frank Act

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  • Zhutong Gu
  • Yixiao Jiang
  • Shuyang Yang

Abstract

Credit Rating Agencies (CRAs) adjust preliminary bond ratings with knowledge beyond publicly available information. These unobserved “soft adjustments” may reflect material nonpublic information and rating biases due to conflicts of interest, making certain bond characteristics endogenous. We model and quantify soft adjustments as bond-specific thresholds in a semiparametric ordered-response model and exploit ownership structures of bond-issuers to control for endogeneity. Relying on the shift restrictions, we develop a location estimator for models of ordered choices with correlated heterogenous thresholds. Using Moody’s initial ratings from 2000 to 2016, we find a significant reduction of soft adjustment after the Dodd–Frank reform.

Suggested Citation

  • Zhutong Gu & Yixiao Jiang & Shuyang Yang, 2023. "Estimating Unobserved Soft Adjustment in Credit Rating Models: Before and after the Dodd–Frank Act," Journal of Financial Econometrics, Oxford University Press, vol. 21(5), pages 1791-1819.
    • Handle: RePEc:oup:jfinec:v:21:y:2023:i:5:p:1791-1819.
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    File URL: http://hdl.handle.net/10.1093/jjfinec/nbac024
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    More about this item

    Keywords

    credit rating; private information; ordered response model; semiparametric estimation; financial reform;
    All these keywords.

    JEL classification:

    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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