Historically, credit ratings were designed to reduce information asymmetries between borrowers and lenders. Credit rating agencies were useful to the extent that they provided economies of scale in gathering and analyzing data or possessed unique expertise that would better able them to assess the credit quality of the firm.
The criticism faced by rating agencies in 2001 due to the late downgrading of Enron and again in 2008 with the slow acknowledgement of the problems at Lehman Brothers leads us to question whether ratings are still useful in the North American context. It is not clear that they maintain an information advantage over other investors or hold specialized expertise in the evaluation of several structured finance products. To use ratings for information purposes, as opposed to regulatory reasons, one must examine the context and ask whether it is a situation in which the rating agencies maintain an advantage. Do they possess better information, gather it more cheaply, or are better able to analyze it than you or I?
While it is not clear that rating agencies maintain these advantages in developed markets they may continue to have the upper hand in emerging markets. Here, information is less widely available for investors and there may be significant barriers or costs for individuals to obtain it. In addition, the securities being assessed are generally standard corporate debt – an area in which rating agencies’ track record is far superior to their recent performance in the analysis of structured securities.
Emerging market firms may be looking to secure a rating from a U.S.-based agency for two reasons. The first is to allow them access to North American financial markets and the pool of capital they represent since most institutional investors will require a rating from a nationally recognized statistical rating organization (NRSRO). The second rationale is that these firms use ratings to signal a commitment to improved financial disclosure and transparency. This rationale stems from the rating agencies’ assessment of the quality of each company’s financial reporting and the extent to which it is overly aggressive in its accounting choices. If firms change their reporting as a result of being rated by a U.S.-based rating agency such as S&P it is possible that the information available about the firm improves. As a result, information asymmetries are reduced and the rating agencies do in fact fulfill their traditional role.
We study rating initiations by S&P using a sample of firms from 18 emerging market countries and find significant evidence that accounting choices are less aggressive once firms secure a rating. This improvement in the information environment appears to have positive impacts for both debt and equity investors. When the rating is first announced, firms experience positive abnormal stock returns. These returns are greatest for firms that previously made particularly aggressive accounting choices and those that improve the quality of their accounting the most. The benefits of improved information spill over to equity analysts as well. We find that the number of analysts following a firm increases significantly after it obtains an S&P rating and that the increase is again greatest for firms with initially poor accounting quality and those that improve their reporting the most.
These findings provide some reassuring counter-evidence to the claim that ratings are no longer useful. Perhaps the issue is not whether they are useful but where they are useful. When ratings were first developed in the U.S. in the early 1900s, markets were in their infancy and individual investors lacked the information or possibly the skill to analyze the credit quality of bonds. Regulation was weaker and accounting standards less developed than they are today. As a result, rating agencies provided additional scrutiny and undertook the costly task of gathering and inspecting data that was of perhaps questionable quality. The similarities to today’s emerging markets are obvious. Our sample countries have poor accounting quality, low judicial impartiality and poorly developed creditor markets. Whether credit rating agencies maintain a useful role for investors may be context-specific. While their benefits in well-developed markets or for innovative structured securities may be small, our evidence suggests some positive benefits in improving the information environment of emerging market firms.
Lynnette Purda is associate professor and RBC Fellow of Finance, Queen’s University