The Role of Bank Quality in Mitigating the Market Reaction to Adverse Rating Agency Announcements Concerning Bank Loans (original) (raw)
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The events linked to the subprime crisis undoubtedly damaged the reputation of credit rating agencies (CRAs), at least in the short and medium-term. In this paper, we intend to gauge the extent of that reputational damage by examining the reaction of the market to rating actions. Using a standard event study methodology, we measure the abnormal return of stock prices in the three-day window centred on the announcement day during the period November 2003-November 2013. Our theory is that the market reaction to downgrades, upgrades and credit watches is lowerafter the crisisthan it used to be due to a lack of trust in the neutrality and reliability of the rating agencies. We expect the phenomenon to be more pronounced for the three major CRAs-Moody's, Standard & Poor's and Fitchwho had more direct involvement in the scandal. For the minor players, the impact of the crisis is potentially twofold. On one side, they may have suffered from a general mistrust of the rating industry. On the other side, they may have benefited from a higher level of attention from investors in search for a cross-check of opinions. The evidence strongly supports the theory of a lower market reaction to rating announcements, especially for the three major agencies. The abnormal returns of equity prices in an event window of a rating action are significantly lower after the crisis than they were before, after considering various explicative factors relating to the features of the announcement and the market conditions in terms of volatility. In line with previous literature on the topic, we find that, due to the "certification" role that many regulations grant to rating agencies, the abnormal return is stronger when the valuation is near to the border between investment and speculative grade. As a consequence, where the certification role is prevalent, there is no difference in the market reaction to announcements before and after the crisis. Conversely, the cumulative abnormal return is significantly lower after the crisis when there is no "regulation-induced" trading and the market investors' behaviour is predominantly guided by the faith put in the informative content of the rating.
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This paper compares conflict of interest incentives and reputational concerns of credit rating agencies (CRAs) in the context of the subprime crisis. We argue that, during up-market periods, ratings levels are affected by both a strong tendency for alignment across CRAs and ratings "shopping" by issuers, while, during periods of economic slowdown, these distortions disappear since CRAs are then more concerned about their long-run reputation. We test our hypotheses by analyzing the gap between Moodys and S&Ps ratings on US residential, subprime mortgage-backed securities before and after the 2007 crisis. Overall, our results show a clear reduction in ratings alignment. Moreover, we find strong evidence that harsher downgrades came from S&P, which had higher ratings before the crisis, and that the gap reduction is strongly correlated with the rating gap before the crisis. We interpret this as evidence that CRAs try to "reverse the gap", to reduce the impact on their (relative) reputation. Finally, we find that harsher downgrades tend to occur for securities not jointly rated and that the relation between downgrades and initial rating is significantly different across the two agencies, this being consistent with the rating shopping hypothesis.