RDP 2004-02: The Impact of Rating Changes in Australian Financial Markets 1. Introduction

Credit rating agencies have become an integral part of the international financial system. The two largest agencies now operate in over 100 countries and assign over 150,000 ratings (White 2001). In Australia, they rate over 500 issuers, which account for nearly all of the outstanding stock of bonds.

The main role of the agencies is to convey opinions to financial markets about the creditworthiness of debt instruments and issuers. To the extent that they are specialists in obtaining and processing information about default risk, the actions of rating agencies reduce lenders' information-gathering costs and thereby facilitate the operation of securities markets. Ratings are also used by regulators in many countries. For example, in the United States rating agencies feature in securities markets regulation and, at a global level, the new Basel Capital Accord is likely to give agencies a role in determining banks' regulatory capital.^[1]

Over the past few years, however, the performance of rating agencies has been widely debated. Rating agencies have been periodically criticised for inaccurate ratings and slow reactions to new information. This criticism has intensified since the collapse of Enron, WorldCom and HIH Insurance, which carried investment grade ratings just a few months before their failure. Such events have also prompted the interest of market regulators. The US Securities and Exchange Commission and the International Organization of Securities Commissions have both issued reports that examine the role of rating agencies in securities markets and discuss areas where rating agencies could be subject to greater regulation.^[2]

The formal evidence on rating agency performance is mixed. At one level, agencies' ratings appear on average to be accurate measures of relative default risk: for example, bonds issued with higher ratings have lower subsequent default rates than lower-rated bonds (Standard & Poor's 2001). In addition, many studies find that security prices react predictably to rating changes, rising after upgrades and falling after downgrades. This implies that rating decisions do provide information for financial markets. But the size of the response is generally quite small and the vast majority of the adjustment in prices around ratings announcements actually appears to occur in the weeks or months prior to the announcement. On balance, this evidence suggests that the decisions of agencies convey little new information to the market.

This paper reports the results of an event study using Australian data, where we examine the extent to which the prices of corporate debt and equity respond to the announcement of changes in ratings. Most earlier studies have used data for the US market, where there is a substantial role for credit ratings in laws and regulations. For example, the Investment Company Act of 1940 ensures money market funds invest only in securities rated in the two highest categories, and the investment grade distinction is important in the Federal Deposit Insurance Act, where corporate debt is only ‘investment grade’ if rated in one of the four highest categories. Given that the portfolio decisions of US investors are affected by the decisions of rating agencies, this raises the possibility that earlier results showing that US market prices respond to rating agency decisions may be partly the result of the regulatory framework. By contrast, there is a more limited regulatory role for credit ratings in the Australian regulatory framework, and the Australian Prudential Regulation Authority's use of credit ratings is restricted to quite technical matters.^[3] Accordingly, the Australian financial market offers a fertile environment for research on the role of ratings where the impact of rating changes can be observed free from major regulatory effects.

Overall, our results are quite encouraging in the sense that – unlike some earlier work – we find that upgrades and downgrades have immediate effects on both debt and equity prices, and that these responses are in the expected direction. However, the impacts are economically small, and there is strong evidence in the case of downgrades and equity returns that rating agencies ‘lag the market’ in the sense that their changes appear to reflect information which has already been factored into prices. We find some evidence – mainly in the bond market – that ratings downgrades have larger impacts on market prices than upgrades. Further, there is some evidence that rating changes have larger effects on equity prices when they relate to smaller firms, when they are relatively unexpected, and when they carry a firm from investment to sub-investment grade.

The plan of the paper is as follows. Section 2 reviews some related literature. Sections 3 and 4 outline the method and data employed. Section 5 presents the results for the analysis of debt and equity prices around rating announcements, while Section 6 concludes with an overall discussion of the results.

Footnotes

Basel Committee on Banking Supervision (2003). [1]

See US Securities and Exchange Commission (2003) and International Organization of Securities Commissions (2003). [2]

General insurers can use credit ratings to determine counterparty risk weightings (General Insurance Guidance Note 110.4); mortgage insurers must be rated at least ‘A’ for Authorised Deposit-taking Institutions (ADIs) to receive a concessional risk weighting for insured mortgages (ADI Guidance Note 102.1); and, ratings are one of the criteria for determining whether certificates of deposit and bank bills can be categorised as ‘high quality liquid assets’ (ADI Prudential Standard 210.0). [3]