Economic Consequences of Reputational Damage to Credit Rating Agencies

Our study documents the direct and spillover costs arising from the loss of reputation for credit rating agencies (CRAs). Credit ratings are essential for a well-functioning debt market, and the integrity of these ratings depends on the reputation of the CRAs. Using data from the unexpected default by AAA-rated ILFS, a large Indian infrastructure finance firm, in what was dubbed “India’s Lehman moment,” we shed light on (a) the economic effects of reputation loss for CRAs, (b) the externalities from such a reputational loss for debt issuers, and (c) CRA response to reputation loss. Unlike in prior studies, we examine publicly listed CRAs, and our setting offers a sharper identification due to the presence of both tainted and untainted CRAs, i.e., CRAs that rated ILFS debt and those that did not. We find that (i) around the dates of the ILFS default, there is a significant decline in the market values of the tainted CRAs, (ii) there is a negative spillover effect on issuers rated by the tainted CRAs, (iii) the tainted CRAs tighten their ratings after this default crisis, and (iv) such an improvement in the quality of ratings helps the tainted CRAs to hold on to their market shares. Collectively, these findings provide useful empirical evidence on the capital market impact of damage to CRAs’ reputations.