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Can Reputation Concerns Always Discipline Credit Rating Agencies? Evidence from Corporate Bond Issuance Ratings

Credit rating agencies have been widely criticized to issue inflated ratings due to the issuer-pay business model. This paper analyzes the corporate bond rating standards and tests whether reputation concerns are powerful enough to discipline the rating agencies. Through a simple theoretical model, I demonstrate that due to rating agencies' distorted incentives, ratings are more likely to be inflated during recessions when investors are more risk-averse and the slope of corporate bond yield curve is higher. The empirical study using a dataset of corporate bond issuance ratings from 1985 to 2010 verifies such prediction and suggests that reputation concerns are not always powerful enough to serve as a self-disciplining mechanism. Besides, I find that the sensitivity of credit ratings on the change of macroeconomic conditions is higher for complex issuers, large issuers who contribute more rating fees, as well as risky issuers. Such findings are also consistent with the model's prediction and provide further evidence for the distorted incentives of credit rating agencies.