Regulating the Credit Ratings Market

Do strict regulatory sanctions, such as banning a rating agency and reducing competition in the ratings market, improve rating quality? Or does an agency’s suspension lead to the unintended consequence of downward biased ratings? Exploiting a rare instance of a regulator sanctioned forced exit of a credit rating agency (CRA) in India, I examine the impact on the rating accuracy of other agencies. Using a difference-in-differences design reveals that the ban on a CRA’s rating services leads to a one-notch rating downgrade in one out of five impacted firms. Further, the rating deflation is associated with a 16% decline in type I errors (missed defaults) but accompanied by an unintended 168% increase in type II errors (false warnings). My findings are consistent with the “pessimistic behavior” hypothesis, wherein incumbent raters issue downward biased ratings to mitigate higher regulatory costs. Further, the ratings decline leads to real consequences: higher borrowing costs for firms that solicit ratings. These findings highlight the unintended consequences of regulator-led forced rating agency exits.