How Did Increased Competition Affect Credit Ratings?

by Bo Becker & Todd Milbourn

Overview — When Fitch Ratings took on Standard & Poor's and Moody's as an alternative credit rating agency in the 1990s, there was a general assumption that the increased competition would lead to higher-quality corporate debt ratings from the incumbents. In fact, their ratings quality declined during the 10-year study period, according to Harvard Business School's Bo Becker and Washington University's Todd Milbourn. One possible cause: competition weakens reputational incentives that drive ratings quality. Key concepts include:

  • The entry of a third major rating agency, Fitch, coincided with lower overall quality, as measured by both the levels and the informational content of incumbents' ratings.
  • Prior to Fitch's growth into a serious competitor, S&P and Moody's faced limited competition for rating corporate bonds. A major concern for the raters was maintaining their reputation with investors as providers of honest, accurate ratings. Increasing competition may force raters to compete harder for issuers' business, reducing their focus on the long term and thereby undermining quality. This appears to have been the case with the additional competition from Fitch. Incumbents' ratings became higher and less informative in those industries where Fitch became more prominent as a rater of corporate bonds.
  • For regulators and policymakers, it is worth considering that increasing competition in the ratings industry involves the risk of impairing the reputational mechanism that seemingly brings about the provision of good quality ratings.

Author Abstract

The credit rating industry has historically been dominated by just two agencies, Moody's and S&P, leading to longstanding legislative and regulatory calls for increased competition. The material entry of a third rating agency (Fitch) to the competitive landscape offers a unique experiment to empirically examine how, in fact, increased competition affects the credit ratings market. Increased competition from Fitch coincides with lower-quality ratings from the incumbents: rating levels went up, the correlation between ratings and market-implied yields fell, and the ability of ratings to predict default deteriorated. We offer several possible explanations for these findings that are linked to existing theories.

Paper Information

  • Full Working Paper Text
  • Working Paper Publication Date: October 2008, revised July 2009, September 2010
  • HBS Working Paper Number: 09-051
  • Faculty Unit(s): Finance