The collapse of the credit system during the 2008 financial crisis was partly blamed on inflated ratings of bonds issued by credit rating agencies (CRAs). Consequently, Congress passed the sweeping Dodd-Frank Wall Street reform bill and the Consumer Protection Act, which among other things sought to make credit ratings more accurate. But a new analysis published in the Journal of Financial Economics by three economists from Rutgers Business School finds that the regulations have badly misfired.
The authors show that fear of new regulatory penalties has made CRAs excessively conservative and that, as a result, their ratings are actually less accurate than they used to be. Parsing corporate bond credit ratings data from 2006 to 2012, they report that the agencies rate bonds as non-investment grade 20 percent more often than before Dodd-Frank and issue false warnings nearly twice as often. When CRAs issue a quality downgrade, they note, stock and bond prices tend to decrease by about half of what they used to do, indicating that investors find the ratings less accurate now.
"We find no evidence that Dodd-Frank disciplines CRAs to provide more accurate and informative credit ratings," conclude the authors. "Instead, following Dodd-Frank, CRAs issue lower ratings, give more false warnings, and issue downgrades that are less informative."