The Impact of Credit Rating Changes on Corporate Disclosures

Information asymmetry between corporate managers and external shareholders preventsthe capital market from functioning well. Various external institutions, such as financialregulators, financial analysts, and bond rating agencies, exist in the capital market tomitigate such information asymmetry and reduce the market friction. On the other hand,managers themselves have incentives to voluntarily disclose proprietary information toseek strategic interests, such as a lower cost of capital. Thus, the observed level ofvoluntary disclosures should reflect the interactions between the external informationproduction and insiders’ disclosure incentives. This proposed study seeks to examine therole played by rating agencies in producing external information and its causal effect onfirms’ disclosure decisions.In 1982, Moody’s refined its previous nine credit rating categories, creating nineteencategories. This refinement provided more precise information about firms’ relativecompetitiveness. But, as claimed by Moody’s, the refinements were not driven by any newinformation about firms’ fundamental changes. Therefore, the refinements imposed anexogenous shock on firms’ credit rating and provide an ideal setting to identify thecausal effect of credit rating changes on firms’ voluntary disclosures.A finer credit rating, releasing more information about a firm’s relative competitiveness,would reduce the firm’s benefits from disclosing proprietary information. But the ratingrefinement does not change the proprietary cost of voluntary disclosures. Therefore, Ipredict that firms will reduce the level of voluntary disclosures after the ratingrefinement. In addition, I expect that the main result is stronger for firms facing higherproprietary costs, as proxied for by the ex ante product market competition.This project can contribute to the literature concerning the role played by bond ratingagencies. As an important information provider, bond rating agencies’ role in shapingfirms’ voluntary disclosure decisions is largely overlooked in empirical studies. The lackof evidence on the causal effect of credit rating changes is primarily due to theendogenous nature of the information disclosed by bond rating agencies. The proposedstudy would employ a natural experiment (Moody’s rating refinements) to get around theendogeneity issue and, thus, has the potential to generate the first evidence of the causaleffect of credit ratings on corporate disclosures. Second, it will advance ourunderstanding of how firms’ optimal disclosure decisions respond to changes in externalsources of information. The proposed project has the potential of documenting a crowdouteffect associated with the finer information provided by rating agencies.