Over the latest twenty years, the average credit rating of U.S. corporations has trended down. This decrease in average credit ratings could be interpreted as indicative of a decline in the actual credit quality of U.S. corporate debt over time. Another interpretation is that the decline in average ratings reflects a tightening of credit standards by agencies, implying a decreasing default probability for a given credit rating.
These two competing explanations are not easy to disentangle, even though they are not mutually exclusive. Examining a sample of investment-grade issuers only over the period 1978 to 1995, Blume, Lim, and MacKinlay (1998) estimate a model of credit ratings using a number of accounting and market risk variables. They interpret the annual intercept as a general measure of credit standards, after controlling for the other variables.
Interestingly, they report a downward trend in the annual intercept, which they interpret as a systematic tightening of ratings standards, ceteris paribus. Indeed, the widely-quoted paper by Blume et al. (1998) has given the impression that credit ratings have become more stringent in the 1990s. Their finding appears to have influenced views on rating consistency by academics, practitioners, and regulators.
This is an interesting result, but hard to explain. Why would the agencies systematically change their ratings standards? No behavioral explanation is advanced. In fact, the agencies argue that they take great pains at ensuring the consistency of their ratings process over time and across firms (Moody's, 2001). Even though agencies are beset by conflicts of interest, it is hard to understand why they would tighten credit standards.
Further, a tightening of credit standards by rating agencies, if it occurred, could undermine the usefulness of credit ratings and have an adverse impact on the cost of debt financing. For instance, for a constant sample of 137 investment-grade firms for the period of 1985 to 2002, we find that the average rating fell from A+ to A?. A drop of two notches translates into higher debt costs. For instance, in 2005, average yields would have increased from 4.98 percent to 5.23 percent, or 25 basis points. Hence, a tightening of standards would result in a significant increase in funding costs, all else equal.
Download
Tightening Credit Standards: The Role of Accounting Quality
