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Is There a "Boom Bias" in Agency Ratings?

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  • Mark Dilly
  • Thomas Mählmann

Abstract

Theory predicts rating agencies’ incentive conflicts to be stronger in boom periods, leading to biased ratings and a reduced level of rating quality. We investigate this prediction empirically based on three different approaches. First, we show that initial ratings disagree with bond spread levels during boom periods in the way that rating agencies hold a systematically more optimistic view. Second, we reveal that boom bond ratings tend to be more heavily downgraded from an ex post perspective; and, third, we demonstrate that boom ratings are inflated compared with "conflicts-free" benchmark ratings. In several robustness tests we show that the observed "boom bias" does not result from changes in credit-worthiness, adjustments in rating standards, competitive pressure, or market supply, but rather from rating agencies’ incentive conflicts.

Suggested Citation

  • Mark Dilly & Thomas Mählmann, 2016. "Is There a "Boom Bias" in Agency Ratings?," Review of Finance, European Finance Association, vol. 20(3), pages 979-1011.
  • Handle: RePEc:oup:revfin:v:20:y:2016:i:3:p:979-1011.
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    File URL: http://hdl.handle.net/10.1093/rof/rfv023
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    1. Ashcraft, A. & Goldsmith-Pinkham, P. & Vickery, J., 2010. "MBS Ratings and the Mortgage Credit Boom," Other publications TiSEM 5da00f7a-44c3-4829-903c-d, Tilburg University, School of Economics and Management.
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    2. Jess N. Cornaggia & Kimberly J. Cornaggia & John E. Hund, 2017. "Credit Ratings Across Asset Classes: A Long-Term Perspective," Review of Finance, European Finance Association, vol. 21(2), pages 465-509.
    3. Kilian R. Dinkelaker & Andreas-Walter Mattig & Stefan Morkoetter, 2019. "A Closer Look at Credt Rating Processes: Uncovering the Impact of Analyst Rotation," Working Papers on Finance 1911, University of St. Gallen, School of Finance.
    4. Amstad, Marlene & Packer, Frank & Shek, Jimmy, 2020. "Does sovereign risk in local and foreign currency differ?," Journal of International Money and Finance, Elsevier, vol. 101(C).
    5. Josephson, Jens & Shapiro, Joel, 2020. "Credit ratings and structured finance," Journal of Financial Intermediation, Elsevier, vol. 41(C).
    6. Chen, Zhongfei & Matousek, Roman & Stewart, Chris & Webb, Rob, 2019. "Do rating agencies exhibit herding behaviour? Evidence from sovereign ratings," International Review of Financial Analysis, Elsevier, vol. 64(C), pages 57-70.
    7. Teixeira, João C.A. & Silva, Francisco J.F. & Ferreira, Manuel B.S. & Vieira, José A.C., 2018. "Sovereign credit rating determinants under financial crises," Global Finance Journal, Elsevier, vol. 36(C), pages 1-13.

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