Executive summary
Credit rating agencies are placed as intermediate between investors and issuers of fixed
income securities. Their most important role is to minimize the existence of asymmetric
information in the marketplace. The role is central in operating the financial markets.
The globalization process and development of complex financial products has provided
the credit rating agencies with a tremendous power.
Despite the powerful position, is the credit rating industry subject to very weak
regulation. The credit rating agencies are by them self supposed to manage potential
pitfalls in the rating process and rating system. They are said to be self-controlled as no
authority control how the agencies manage to avoid potential pitfalls. The weak
regulation and self-control provides the agencies with a high level of freedom.
The mixture of power and freedom is a dangerous combination, if not managed well.
The agencies need to be fully aware of the responsibilities that naturally follow power
and freedom. If they don’t act as a responsible intermediate and perform trustworthy,
the market will loose its faith to the system.
The credit rating agencies have through the years been subject to criticism in relation to
the management of their responsibility. The criticism has evolved in the wrong direction
after focus had been pointed to the agencies role in the corporate scandals of Enron,
WorldCom and Pharmalat. The criticism has reached a new high level under the current
financial crisis. Many players at the financial scene look upon the credit rating agencies
as a direct scapegoat of the current crisis. The criticism has been concentrated on
numerous conflicts of interest and the dependence of issuers.
It is expected that the criticism have a negative influence on the image of the credit
rating agencies and the investor’s confidence in the credit rating system. The credit
rating agencies can only exist if they have a strong reputation and enjoy great
confidence. The credit rating agencies has realized the problem and declared that
improvements are needed to restore the confidence and image.
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This situation motivates an investigation of the nature of the criticism and the influence
on investor’s reactions on changes in long-term corporate credit rating. Have the
investors as a result of low confidence ignored the changes or are they reacting on
information from criticized credit rating agencies. Agencies who, by them self, have
admitted the many problems the critics have pointed out.
The main findings reveal that investors only react significant on downgrades during the
current crisis. There is no significant reaction in the months before the crisis. This is
seen as an expected result of the criticism and an erosion of the investors trust in the
credit rating system. The sudden reaction during the crisis is much more significant,
than results in earlier studies. The investor reaction measured as negative abnormal
stock returns can be characterized as a “panic-drop”. It is believed to be a psychological
reaction and not a sudden rebuild trust in the credit rating system. In the case of
upgrades, no significant reaction was found.
Chapter 1 works as introduction and present the problem statement. Chapter 2 describes
the credit rating system from a critical viewpoint and points out the source of the main
criticism. Chapter 3 presents the behavioural finance theories behind the credit rating
system and analyse the role and power of the credit rating agencies. The main criticism
of the role and the related power are also discussed. Chapter 4 perform an event study to
investigate the investor reaction on changes in long-term corporate credit ratings to see
if the criticism has had any effect. Finally chapter 5 contains the conclusion of the
problem statement.
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