The Impact of the Contractual Use of Ratings on the Rating Process - Evidence from Rating Agency Adjustments

I study the use of credit ratings in debt contracts. When debt contracts use credit ratings rather than accounting ratios to enforce restrictions on borrowers, there is likely to be increased pressure on rating agencies to cater to borrower incentives. I investigate whether the explicit use of ratings in contracts affects rating agencies' incentives to issue more favorable credit risk assessments than justified by the underlying economics. I focus on performance pricing (PP) agreements which are now widespread in lending agreements and which use either ratings or accounting ratios to calibrate pricing grids. I examine whether, ceteris paribus, rating agencies are more likely to cater to borrowers when PP agreements use ratings rather than accounting ratios to administer PP agreements so that rating changes directly impact borrowers' cash flows. I use data from Moody's to investigate this prediction and report evidence from a number of tests that is consistent with the catering hypothesis