Market dynamics associated with credit ratings: a literature review
Credit ratings produced by the major credit rating agencies (CRAs) aim to measure the creditworthiness, or more specifically the relative creditworthiness of companies, i.e. their ability to meet their debt servicing obligations. In principle, the rating process focuses on the fundamental long-term credit strength of a company. It is typically based on both public and private information, except for unsolicited ratings, which focus only on public information. The basic rationale for using ratings is to achieve information economies of scale and solve principal-agent problems. Partly for the same reasons, the role of credit ratings has expanded significantly over time. Regulators, banks and bondholders, pension fund trustees and other fiduciary agents have increasingly used ratings-based criteria to constrain behaviour. As a result, the influence of the opinions of CRAs on markets appears to have grown considerably in recent years. One aspect of this development is its potential impact on market dynamics (i.e. the timing and path of asset price adjustments, credit spreads, etc.), either directly, as a consequence of the information content of ratings themselves, or indirectly, as a consequence of the “hardwiring” of ratings into regulatory rules, fund management mandates, bond covenants, etc. When considering the impact of ratings and rating changes, two conclusions are worth highlighting. – First, ratings correlate moderately well with observed credit spreads, and rating changes with changes in spreads. However, other factors, such as liquidity, taxation and historical volatility clearly also enter into the determination of spreads. Recent research suggests that reactions to rating changes may also extend beyond the immediately-affected company to its peers, and from bond to equity prices. Furthermore, this price reaction to rating changes seems to be asymmetrical, i.e. more pronounced for downgrades than for upgrades, and may be more significant for equity prices than for bond prices. – Second, the hardwiring of regulatory and market rules, bond covenants, investment guidelines, etc., to ratings may influence market dynamics, and potentially lead to or magnify threshold effects. The more that different market participants adopt identical ratings-linked rules, or are subject to similar ratings-linked regulations, the more “spiky” the reaction to a credit event is likely to be. This reaction may include, in some cases, the emergence of severe liquidity pressures. Efforts have recently been made, notably with support from the rating agencies themselves, to encourage a more systematic disclosure of rating triggers and to renegotiate and smooth the possibly more destabilising forms of rating triggers. However, the lack of a clear disclosure regime makes it difficult to assess how far this process has evolved. Questions also remain as to the extent to which ratings-based criteria introduce a fundamentally new element into market behaviour, or, conversely, the extent to which they are simply a va riant of more traditional contractual covenants. Rating agencies strive to provide credit assessments that remain broadly stable through the course of the business cycle (rating “through the cycle”). Agencies and other analysts frequently contrast the fundamental credit analysis on which ratings are based with market sentiment — measured for example by bond spreads — which is arguably subject to more short-term influences. Agencies are adamant that they do not directly incorporate market sentiment into ratings (although they may use market prices as a diagnostic tool). On the contrary, they make every effort to exclude transient market sentiment. However, as reliance on ratings grows, CRAs are being increasingly expected to satisfy a widening range of constituencies, with different, and even sometimes conflicting, interests: issuers and “traditional” asset managers will look for more than a simple statement of near-term probability of loss, and will stress the need for ratings to exhibit some degree of stability over time. On the other hand, mark-to-market traders, active investors and risk managers may seek more frequent indications of credit changes. Hence, in the wake of major bankruptcies with heightened credit stress, rating agencies have been under considerable pressure to provide higher-frequency readings of credit status, without loss of quality. So far, they have responded to this challenge largely by adding more products to their traditional range, but also through modifications in the rating process. The rating process and the range of products offered by rating agencies have thus evolved over time, with, for instance, an increasing emphasis on the analysis of liquidity risks, a new focus on the hidden liabilities of companies and an increased use of market-based tools. It is too early, however, to judge whether these changes should simply be regarded as a refinement of the agencies’ traditional methodology or whether they suggest a more fundamental shift in the approach to credit risk measurement. For the same reason, it is not possible to draw any firm conclusions about changes in the effects of credit ratings on market dynamics.
Volume (Year): (2004)
Issue (Month): 4 (June)
|Contact details of provider:|| Postal: |
Web page: http://www.banque-france.fr/
More information through EDIRC
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Henning Ahnert & Geoff Kenny, 2004. "Quality adjustment of European price statistics and the role for hedonics," Occasional Paper Series 15, European Central Bank.
- Geske, Robert, 1977. "The Valuation of Corporate Liabilities as Compound Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(04), pages 541-552, November.
- Richard Johnson, 2003. "An examination of rating agencies' actions around the investment-grade boundary," Research Working Paper RWP 03-01, Federal Reserve Bank of Kansas City.
- Eva Catarineu-Rabell & Patricia Jackson & Dimitrios P. Tsomocos, 2002.
"Procyclicality and the New Basel Accord: banks' choice of loan rating system,"
Conference Series ; [Proceedings],
Federal Reserve Bank of Boston.
- Eva Catarineu-Rabell & Patricia Jackson & Dimitrios Tsomocos, 2005. "Procyclicality and the new Basel Accord - banks’ choice of loan rating system," Economic Theory, Springer, vol. 26(3), pages 537-557, October.
- Eva Catarineu-Rabell & Patricia Jackson & Dimitrios P Tsomocos, 2003. "Procyclicality and the new Basel Accord - banks' choice of loan rating system," Bank of England working papers 181, Bank of England.
- Eva Catarineu-Rabell & Patricia Jackson & Dimitrios P. Tsomocos, 2003. "Procyclicality and the new Basel Accord–banks’ choice of loan rating system," LSE Research Online Documents on Economics 24863, London School of Economics and Political Science, LSE Library.
- Dimitrios P Tsomocos & Eva Catarineu-Rabell, 2003. "Procyclicality and the new Basel Accord - Banks` choice of loan rating system," Economics Series Working Papers 2003-FE-06, University of Oxford, Department of Economics.
- Eva Catarineu-Rabell & Patricia Jackson & Dimitrios P.Tsomocos, 2003. "Procyclicality and the new Basel Accord - Banks' choice of loan rating system," OFRC Working Papers Series 2003fe06, Oxford Financial Research Centre.
- Dimitrios Tsomocos & Eva Catarineu-Rabell & Patricia Jackson, 2003. "Procyclicality and the new Basel Accord–banks’ choice of loan rating system," FMG Discussion Papers dp464, Financial Markets Group.
- Merton, Robert C, 1974.
"On the Pricing of Corporate Debt: The Risk Structure of Interest Rates,"
Journal of Finance,
American Finance Association, vol. 29(2), pages 449-70, May.
- Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
- Andrea Resti & Andrea Sironi, 2005. "The Basel Committee Approach To Risk-Weights And External Ratings: What Do We Learn From Bond Spreads?," Temi di discussione (Economic working papers) 548, Bank of Italy, Economic Research and International Relations Area.
- Caton, Gary L & Goh, Jeremy, 2003. " Are All Rivals Affected Equally by Bond Rating Downgrades?," Review of Quantitative Finance and Accounting, Springer, vol. 20(1), pages 49-62, January.
- Pierre Collin-Dufresne, 2001. "The Determinants of Credit Spread Changes," Journal of Finance, American Finance Association, vol. 56(6), pages 2177-2207, December.
- Ilia D. Dichev, 2001. "The Long-Run Stock Returns Following Bond Ratings Changes," Journal of Finance, American Finance Association, vol. 56(1), pages 173-203, 02.
- Griffin, Paul A & Sanvicente, Antonio Z, 1982. " Common Stock Returns and Rating Changes: A Methodological Comparison," Journal of Finance, American Finance Association, vol. 37(1), pages 103-19, March.
- Holthausen, Robert W. & Leftwich, Richard W., 1986. "The effect of bond rating changes on common stock prices," Journal of Financial Economics, Elsevier, vol. 17(1), pages 57-89, September.
- Nickell, Pamela & Perraudin, William & Varotto, Simone, 2000.
"Stability of rating transitions,"
Journal of Banking & Finance,
Elsevier, vol. 24(1-2), pages 203-227, January.
- Doron Kliger & Oded Sarig, .
"The Information Value of Bond Ratings,"
Rodney L. White Center for Financial Research Working Papers
13-97, Wharton School Rodney L. White Center for Financial Research.
- Edwin J. Elton, 2001. "Explaining the Rate Spread on Corporate Bonds," Journal of Finance, American Finance Association, vol. 56(1), pages 247-277, 02.
- G. Ferri & L.-G. Liu & J. E. Stiglitz, 1999. "The Procyclical Role of Rating Agencies: Evidence from the East Asian Crisis," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 28(3), pages 335-355, November.
- Hand, John R M & Holthausen, Robert W & Leftwich, Richard W, 1992. " The Effect of Bond Rating Agency Announcements on Bond and Stock Prices," Journal of Finance, American Finance Association, vol. 47(2), pages 733-52, June.
- Lando, David & Skodeberg, Torben M., 2002. "Analyzing rating transitions and rating drift with continuous observations," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 423-444, March.
- Til Schuermann & Yusuf Jafry, 2003. "Measurement and Estimation of Credit Migration Matrices," Center for Financial Institutions Working Papers 03-08, Wharton School Center for Financial Institutions, University of Pennsylvania.
- Levy, S., 2002. "The development of contingency clauses: appraisal and implications for financial stability," Financial Stability Review, Banque de France, issue 1, pages 103-115, November.
- Bank for International Settlements, 2003. "Incentive structures in institutional asset management and their implications for financial markets," CGFS Papers, Bank for International Settlements, number 21, Autumn.
When requesting a correction, please mention this item's handle: RePEc:bfr:fisrev:2004:4:1. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Michael brassart)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.