Regulating credit rating agencies: Reducing the conflict of interest in the bond market

Legislative action during the financial crisis of 2008 aimed to reduce the conflict of interestproblem in the credit rating industry. To test whether the informational content of ratings hasimproved, or investors lost their trust in credit rating agencies, I study the impact of creditrating events (CREs) on daily bond returns. Additionally, this paper compares the issuer paysmodel to the investor pays model using credit ratings from Standard & Poor’s and Egan-JonesRating. I find new evidence that daily bond returns are significantly impacted by CREs. Mostof my results suggest that the impact is more pronounced in the post-crisis period, in linewith the improved-information hypothesis. My results provide evidence that the significantdifference between periods is mostly driven by the impact of CREs on bonds with financialissuers. Comparing EJR to S&P, my results suggest that the conflict of interest problem isstill troubling in the post-crisis period. Namely, S&P provides on average 0.151 notch higherratings compared to EJR and this difference is largely explained by the level of current debt.Additional analyses provide evidence that issuers exploit this rating inflation by increasingtheir debt at a lower cost of capital. Although rating inflation is still present in the post-crisisperiod, this research provides evidence for the usefulness of legislation to reduce the conflictof interest problem. Additional legislation is potentially effective in reducing the conflict ofinterest and its rating inflation.