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Sourcing the Bias in Credit Ratings

By Marcin Kacperczyk, Assistant Professor of Finance

Marcin Kacperczyk on credit rating bias

The more suppliers of information covering the firm or issuer of credit in our context, the more costly it will be for the issuer to keep unfavorable news suppressed.

Much of the blame for the financial crisis of 2008 has been laid at the door of the three dominant credit rating agencies (CRAs), largely because they were paid by the very institutions whose credit-worthiness they rated. But according to new research by NYU Stern Professor Marcin Kacperczyk, the story is more complicated.

In “Do Security Analysts Discipline Credit Rating Agencies?,” Kacperczyk and co-authors Harrison Hong, Kingsley Fong, and Jeffrey Kubik investigated whether the number of analysts reporting on a particular company could also inject some bias into credit ratings. “Intuitively,” they write, “the more suppliers of information covering the firm or issuer of credit in our context, the more costly it will be for the issuer to keep unfavorable news suppressed.”

The authors studied coverage and ratings for more than 2,900 publicly traded companies during between 1985 and 2005.

They realized that when brokerage houses merge, often the number of analysts assigned to a particular company is cut back, for efficiency purposes. Within this context, they were able to compare how a company’s ratings fared before and after the reduction. They found that the fewer the analysts, the higher the credit rating – by about half a ratings notch. This effect was most noticeable with companies initially covered by fewer than five analysts.

Because how analysts view a company’s equity or debt is one of the factors that shape its credit rating, Kacperczyk concluded that competition among analysts could function as a disciplining force on CRAs.