Regulating Credit Rating Agencies

Regulating Credit Rating Agencies

Elgar Financial Law series

Aline Darbellay

This highly topical book examines how the leading credit rating agencies – Moody's, Standard & Poor’s and Fitch – have risen to prominence in the wake of the financial crisis.

Chapter 11: Market reactions to credit rating downgrades and their consequences

Aline Darbellay

Subjects: law - academic, finance and banking law

Extract

Due to the over-reliance on a concentrated credit rating market, participants tend to react homogeneously to rating announcements. This homogenization of market behavior is especially acute in the face of extreme events. Massive rating downgrades often occur as a cause or as an immediate trigger of financial turmoil. First, market participants tend to rely on ratings as a homogeneous source of financial information. Various factors have homogenized the market for credit information:CRAs have become a preferred source of credit information as opposed to other gatekeepers. The high concentration in the rating industry gives a privilege to information stemming from the leading CRAs as compared with smaller CRAs. The three leading CRAs issue a significant percentage of the totality of the ratings. The issuer-pays business model incentivizes the leading CRAs to attribute investment-grade ratings to most debt instruments. Under an issuer-pays business model, information is further made easily available to a wide range of investors. Second, the very fact that a rating downgrade has occurred not only reflects information but is autonomous information. Even when no additional information about the present financial situation of the company is conveyed, investors will react to the rating announcement. Many market participants react to rating downgrades not because they think that the downgrades convey new information, but because they know that the financial markets will react negatively to them.

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