Recent decades have seen extraordinary growth in cross-border debt financing as financial systems become more globally integrated and companies take advantage of foreign markets to share risk, increase liquidity, and obtain cheaper capital. In the first study to comprehensively identify corporate rating patterns for a broad set of international firms, HKUST professors Mingyi Hung and Shiheng Wang and their colleagues examine how the market power of credit rating agencies (CRAs) affects their rating standards. They “find that global CRAs issue more inflated ratings following a decline in their market power.”

Global CRAs are more informative than local CRAs because global CRAs have a wider client base and can be more consistent across geographical areas and global benchmarks can be set. The authors observe that “local CRAs are considered to have an information advantage over global CRAs due to their local knowledge and regulatory support.”

However, the authors add that “local CRAs’ ratings are more inflated and less informative than the ratings of global CRAs.” This leads to a trade-off between local CRAs’ in-depth knowledge and global CRAs’ reputation. Global CRAs do not generally compete against each other; they compete against local CRAs.

Using a large global sample spanning 25 years, the authors show that variations in S&P and Moody’s market power contribute to differences in rating policies between countries. The quality of credit ratings changes in response to visible threats to the reputation of CRAs, which leads to stricter rating standards, timelier ratings, and increasing false warnings. In addition, they find that “investors partially undo the effect of overly stringent ratings when pricing the default risk.”

The authors further used the U.S. SEC’s 2007 NRSRO certification of Japan Credit Rating Agency (JCR) to corroborate their findings on the association between the stringency of corporate credit ratings when global CRAs have greater market power in the Japanese corporate rating market.

The authors focus on the change in S&P’s rating policies following the certification and find that “S&P’s market share in Japan experiences an inverse-U shape change, starting at 31% in 1994, peaking at 79% in 2004, and gradually decreasing to 29% in 2018.” In contrast, the market share of JCR increased from 25% in its early years to about 70% at the time of the NRSRO designation, but decreased to 60% after 2007. Consistent with their prediction, Japanese firms experience an increase in S&P ratings after JCR received NRSRO classifications and S&P’s market power is weakened in Japan, relative to other countries.

The authors conclude that “the growing market power of global CRAs is associated with stricter ratings.” This study has important policy implications, not least because regulators have called for increasing competition in the credit rating industry because of the dominance of some incumbent CRAs.