Type of Document Dissertation Author Prakash, Puneet URN etd-08042005-152025 Title Absolute or Relative? Which Standards Do Credit Rating Agencies Follow? Degree Ph.D. Department Risk Management and Insurance Advisory Committee
Advisor Name Title Richard D Phillips Committee Chair Ajai Subramanian Committee Member Jayant R Kale Committee Member Neil A Doherty Committee Member Sanjay Srivastava Committee Member Keywords
- Ordered Probit
- Structural Model
- Ratings
- Default Risk
- Absolute or Relative
- Credit Ratings
Date of Defense 2005-07-18 Availability restricted Abstract Despite the recognized importance of the bond rating industry, little academicwork has been done to investigate the determinants of the standards these firms employ to
assign credit ratings to individual firms. There is an ongoing debate in the literature
arguing whether the decline in the percentage of highly rated firms is because rating
standards have become more stringent over time or whether the credit quality of firms in
the economy has declined. We investigate this question in this dissertation.
Our first contribution is to address several empirical problems in prior literature.
This study uses a combination of structural models of default and econometric model of
ratings to study the determinants of rating standards and, by doing so, overcome the
earlier methodological shortcomings.
Our second contribution is to test new theory which hypothesizes that the
standards of a rating agency are conditional upon the distribution of default risk in the
economy at the time. The results are robust no matter which structural models of default
we employ. The evidence suggests the standards are relative to the default risk
distribution and there has been a secular increase in the stringency in the assignment of
ratings over time.
A third way we extend the literature is by examining the accuracy of the
assignment of ratings. Theoretical models suggest rating agencies have incentives to
purposefully add noise to the assignment of ratings. We conduct an empirical analysis of
the classification errors using receiver operating characteristic analysis. The results
suggest that error rates have decreased at the extreme ends of the rating spectrum (AAA
vs. AA and below; B and below vs. BB and above) over time while it has increased in the
middle rating categories. This error rate is directly related to the distribution of default
risk across firms at any point in time. These findings not only strengthen our result that
standards are relative and time varying, but also suggest there is more noise in the
assignment of ratings at exactly the time when there is more uncertainty regarding the
credit risk of firms in the economy – i.e., during a credit crisis.
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