Do Solicitations Matter in Bank Credit Ratings? Results from a Study of 72 Countries
Poon, Winnie P. H., Lee, Junsoo, Gup, Benton E., Journal of Money, Credit & Banking
UNSOLICITED BANK CREDIT ratings assigned to banks by nationally recognized statistical rating organizations (NRSROs), such as Standard & Poor's Ratings Services (S&P's) and Moody's Investor Service (Moody's), are controversial. Credit ratings that are initiated and paid for by issuers are called "solicited ratings," and credit ratings that are not paid for by the issuing firm are called "unsolicited ratings." The U.S. Department of Justice (DOJ) has recommended that the U.S. Securities and Exchange Commission (SEC) require rating agencies to disclose when credit ratings are unsolicited (Gasparino 1996a). The DOJ (1998) stated that "'unsolicited' ratings may not be as accurate as ratings by retained agencies.... When unsolicited ratings are not based on the same type of information as solicited ones, the ratings agency runs the risk that its rating is not accurate." Based on the survey of Baker and Mansi (2002), there are concerns that unsolicited ratings are less accurate than ratings that are paid for in the traditional manner because the rating agency does not have access to confidential information in the traditional ratings process.
Rating agencies encounter potential conflicts of interest because they serve both issuers and investors (Baker and Mansi 2002). Investors are the main users of credit ratings, but fees paid by the issuers are the principal source of income of the agencies. For example, about 90% of Moody's and Fitch's revenues come from issuer fees (SEC 2003). Michael Oxley (2004), chairman of the House Committee on Financial Services, said in hearings about "The Ratings Game" that "officials from Northern Trust Corporation have stated that the major rating agencies have requested payment for unsolicited ratings and strong-armed the company to pay the fees in return for a good rating. Northern Trust is not the only company to register a complaint about these practices." The following year, Oxley (2005) also stated in hearings about "Reforming Credit Rating Agencies" that "given the inherent conflicts and evidence that unsolicited ratings tend to be lower, this practice begs for reform, if not outright prohibitions."
In 2005, Eliot Spitzer, New York State attorney general, subpoenaed Moody's for documents related to the company's unsolicited credit ratings and other credit-rating practices (Klein 2005, Stempel 2005). James Kaitz, president and chief executive officer of the Association for Financial Professionals, said that issuers often feel compelled to participate in the rating process and pay for the unsolicited rating. He asked the SEC to explore the potential for abuse in unsolicited ratings (McTague 2005). On the other side of the rating process, Kathleen Corbet, during her tenure as president of S&P's, defended unsolicited ratings on the grounds that they benefit the market and said that the company issued these ratings only if there was meaningful market interest and adequate public disclosure by the issuer (McTague 2005). Moody's (1999) considers the assignment of unsolicited ratings to be the market's best defense against rating shopping. Rate shopping occurs when issuers shop among various agencies for the highest ratings and to suppress lower conclusions.
Against this background, the main research issues that we examine are whether the credit ratings of unsolicited banks would be higher if they were solicited, and alternatively, whether the credit ratings of solicited banks would be lower if they were unsolicited. These issues are complicated as they must be answered by taking into account: (i) the differences in the financial characteristics of the two groups (the clientele effect), (ii) the potential self-selection bias whereby better firms may self-select to be rated and poor-quality firms may not request to be rated, and (iii) the differences in the importance of the same factors in determining the ratings of the banks between the two groups. As the next section shows, previous studies in the literature have not addressed these hypothetical questions. …