Research On Functions, Defects And Market Structure Of Credit Rating Industry

Based on information asymmetry theory, financial arrangement theory and industrial organization theory, this paper adopts normative and empirical methods to study the functions of credit rating industry, analyze endogenous defects existing in credit rating industry and explore reasonable market structure for credit rating industry. Credit rating industry is financial intermediary composed of credit rating agencies and engaged in credit rating business. It is the intermediary between rating objects and investors. It could provide information about credit risk of rating objects to investors and provide reference for investment decisions of investors. Credit ratings provided by credit rating industry are graduated symbols reflecting future paying risk of rating objects according to certain rating techniques, based on information about rating objects. Credit rating could be divided into sovereign credit rating for countries, firm credit rating for companies and bond credit rating for bonds according to rating objects.Although three types of credit ratings provided by credit rating industry, such as sovereign credit ratings, bond credit ratings and firm credit ratings, respectively play an important role in economy growth, financing arrangement in firms and capital markets, the performance of credit rating industry during international financial crisis is questioned. Before the crisis broke out, international credit rating agencies including Standard & Poor’s, Moody’s and Fitch, cannot play their unique functions and give necessary warnings for investors. They have many defects such as cyclical behaviors. Aiming at the defects of credit rating industry, scholars try to restrict the behaviors of credit rating agencies from the perspective of building suitable market structure for credit rating industry. So what kinds of functions do three different types of credit ratings play, including sovereign credit ratings, firm credit ratings and bond credit ratings provided by credit rating industry? Are cyclical behaviors endogenous defects of credit rating industry? Is there optimal competition level existing in credit rating industry in China to reduce the defects? This paper will do systematic theoretical and empirical analysis for functions, defects and market structure for credit rating industry in China based on the current literature.The research framework changes from normative to empirical analysis. After introducing research background, research questions and innovations in Chapter One, Chapter Two reviews domestic and foreign literature for functions of credit rating industry, defects in credit rating industry and solutions of credit rating industry defects. Research has reached an agreement about functions of three types of credit ratings provided by credit rating industry. Sovereign credit rating can affect the financing cost of sovereign debt and capital flow among countries. It could also influence the macro economy growth. It has the function of providing country credit risk information to investors and guiding allocation of resources between countries. Firm rating is closely related to many firm financial arrangements and has the function of reducing firm debt financing constraints. Bond rating can reduce information asymmetry in capital markets and reduce financing cost of bonds. Although three different types of credit ratings provided by credit rating industry have different functions, cyclical behaviors, ineffectiveness of reputation mechanism, conflict of interest and rating inflation are mains defects in credit rating industry, which lead to inaccurate credit rating. Aiming at defects of credit rating industry, related literature proposes to build reasonable market structure for credit rating industry, adopt investor-paying mode, strengthen regulation and build incentive and restraint mechanism as solutions. The developing history of credit rating industry in China is short. The operating pattern mainly imitates international credit rating industry. The theoretical and empirical analysis of credit rating industry in China relatively lags behind. Therefore, theoretical analysis frame abroad and characteristics of credit rating industry development in China should be used to demonstrate and test the functions, defects and market structure of credit rating industry.Chapter Three, Four and Five analyze functions of credit rating industry from the perspectives of sovereign credit rating, firm credit rating and bond credit rating. Chapter Three explores how sovereign credit rating provided by credit rating industry affects economy growth in domestic countries and other countries in Eurozone. It also examines the heterogeneous effect during debt crisis. Empirical results find that sovereign upgrade could result in increase of domestic economic growth rate while downgrade leads to the decrease of growth rate. The negative effect of downgrades on domestic growth rate is smaller during debt crisis. Meantime, downgrades in one country could bring reduction of economic growth rate in other countries. Upgrade does not show the effect on economy growth in other countries. During the period of debt crisis, the effect of downgrade on economy growth in other countries is weaker. Furthermore, for countries with higher trade deficit, smaller economy size, sovereign rating level lower than A1, real downgrade and before joining in Eurozone, the negative impact of downgrades on economic growth rate is bigger. For countries with more times of rating change, the positive impact of upgrades on economic growth is stronger. Empirical results testify that sovereign credit rating could provide country credit risk information to investors and has the function of guiding resource allocation among countries. Chapter Four turns the research objects from macro economy to micro economic entities. It examines the effect of firm ratings on choice of payment method in mergers and acquisitions. Results show that bidders with firm ratings and higher firm ratings pay more cash and tend to use cash as the payment method. The effect of firm credit rating existence on payment method is weaker when information asymmetry is higher. Empirical results indicate that firm ratings have the function of reducing firm debt financing constraints. Chapter Five adopts private bonds issued by small and medium-sized private firms in bond markets in China, which has higher information asymmetry. This chapter explores the effect of bond ratings on the financing cost of private bonds. The results show that higher bond ratings could reduce financing cost of private bonds. For private bonds issued by non-state-owned firms and firms disclosing no financial information, the effect of bond credit ratings on financing cost is larger. Empirical results indicate that bond credit rating has the function of reducing information asymmetry in capital markets.Chapter Six turns to analyze the endogenous defects of credit rating industry in China and explore if cyclical behaviors exist in Chinese credit rating industry. Empirical evidence indicates that credit rating agencies are more likely to inflate ratings and the information value of credit ratings is lower in economic boom compared to economic depression. Empirical results indicate that rating accuracy of credit rating agencies decrease in economic boom, which may mislead investors’ judgment and result in risk accumulation.How to solve the endogenous defects of credit rating industry, such as cyclical behaviors, is one of important topics discussed by regulators in each country and international finance scholars after the crisis. Chapter Seven tries to explore which kind of market structure is suitable for Chinese credit rating industry to reduce defects of rating industry. Empirical results show that credit ratings are lower and ratings are more likely to be downgraded when competition in Chinese credit rating industry becomes more fierce. It means that competition can reduce the probability of rating inflation. Further, the sensitivity of bond yield spread to rating becomes larger when competition becomes more fierce. This implies that competition improves the information value of credit ratings. The results in the two aspects indicate that more fierce competition helps to improve the accuracy of credit ratings. Besides, for non-state-owned companies, companies in lower market level cities and companies rated by credit rating agencies in better law environment, the positive effect of competition on accuracy of credit ratings is more obvious. Furthermore, this paper analyzes if there exists optimal competition level in Chinese credit rating industry. Results indicate that when competition increases, rating accuracy firstly increases and then decreases. Credit rating industry in China should adopt market structure of moderate competition. At last, Chapter Eight is research conclusion, policy proposal and prospects of the whole paper.In whole, this paper follows the advanced research methods in foreign literature and considers the special circumstances in Chinese credit rating industry. It explores the functions of three types of credit ratings, the cyclical issues in credit rating industry and find the solutions for credit rating defects from the perspective of building suitable market structure. This paper has broken through the previous descriptive and qualitative analysis in previous domestic study. It adopts empirical methods to do a systematic study on questions relating to credit ratings. This paper has certain implications for building a healthy and perfect credit rating industry in China. It also provides theoretical and empirical support for optimizing financial resource allocation in China.