The very broad language of the act seems to have of had some significant impact in agency behavior.
In response to the Global Financial Crisis of 2008-2009, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in July 2010. Among its various provisions, Dodd-Frank outlines a series of broad reforms to the Credit Rating Agencies (CRA) market. Many observers believe that CRAs’ inflated ratings of structured finance products were partly to blame for the rapid growth and subsequent collapse of the shadow banking system. In response, Dodd-Frank’s CRA provisions significantly increase CRAs’ liability for issuing inaccurate ratings, and make it easier for the SEC to impose sanctions and bring claims against CRAs for material misstatements and fraud.
In our paper, Impact of the Dodd-Frank Act on Credit Ratings, forthcoming in the Journal of Financial Economics, we examine whether Dodd-Frank achieves its stated objective of improving the quality of credit ratings, or whether the law unintentionally leads to a loss of relevant information in the CRA market. The quality of credit ratings may improve as the law encourages CRAs to invest in due diligence, strengthen internal controls and corporate governance, and improve their methodology (disciplining effect). Alternatively, CRAs may respond to the greater threat of legal and regulatory action by lowering their ratings beyond a level justified by an issuer’s fundamentals (reputation effect). Doing so helps CRAs protect their reputation in a market where issuing overly optimistic ratings is expected to have far greater legal and regulatory costs than issuing overly pessimistic ratings. As CRAs lower their ratings regardless of their information, investors rationally discount CRAs’ rating downgrades and some valuable information is lost to the market. Using a comprehensive sample of corporate credit ratings from 2006 to 2012, we find strong support for the reputation effect. We document:
- Lower corporate bond ratings, on average, in the post-Dodd-Frank period (defined as the period from July 2010 to May 2012). The odds that a corporate bond is rated as non-investment grade are 1.19 times greater after the passage of Dodd-Frank, holding all else constant.
- More false warnings in the post-Dodd-Frank period, where false warnings are defined as speculative grade rated issues that do not default within one year. The odds of a false warning are 1.84 times greater after the passage of Dodd-Frank, holding all else constant.
- Lower bond market reaction to credit rating downgrades (but not to credit rating upgrades) in the post-Dodd-Frank period. Prior to the passage of Dodd-Frank, bond prices decrease on average by 1.023% following a rating downgrade; this compares to a decrease of 0.654% following the passage of Dodd-Frank.
- Lower stock market reaction to credit rating downgrades (but not credit rating downgrades) in the post-Dodd-Frank period. Stock prices decrease by 2.461% following a rating downgrade in the pre-Dodd-Frank period; in the post-Dodd-Frank period, the decrease is only 1.248%.
To summarize, credit ratings are lower, less accurate, and less informative to the market following the passage of Dodd-Frank. It appears that the reputation effect outweighs the disciplining effect of Dodd-Frank in the market for corporate bond credit ratings.