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| The Abolition of Mandatory Credit Ratings, Rating Agency Reputation, and Credit Rating Quality: Evidence from China's Bond Market |
| LIAN Lishuai, ZHU Song
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| School of Economics and Management, East China Normal University |
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Abstract Given the important role of credit ratings in mitigating information asymmetry, regulation relies on such ratings, as reflected in regulatory conditions being set based on credit ratings in the bond issuance process. This is manifested in three aspects of the process: first, the issuer needs to provide a credit rating in the bond issuance process; second, the success of bond issuance depends on the credit rating; and third, the issuer is required to provide simultaneously both issuer and facility ratings. Although the regulation requiring credit ratings as a criteria for bond issuance aims to improve issuance quality, it raises a series of issues. First, to meet the requirements for bond issuance, credit ratings are concentrated at specific thresholds. For example, because the regulatory requirement for bond issuance is that the credit rating is not lower than AA, the majority of bonds in the Chinese market are rated AA and above. This is problematic because it leads to insufficient differentiation in credit ratings, which cannot accurately reflect the default risk of issuers. In addition, it can result in credit rating inflation, reducing the quality of credit ratings. The aim of disclosing facility credit ratings and guarantees is not to provide incremental information but to enable issuers to enhance their credit to achieve a higher rating if their initial rating is insufficient, and thus to improve the overall credit rating and increase the success rate of bond issuance. The People's Bank of China clearly pointed out in December 2020 that “problems such as false high ratings, insufficient differentiation and weak pre-warning function have restricted the high-quality development of China's bond market.”
In response to these issues, the credit rating regulation policy was adjusted in 2021. On February 26, 2021, the “Management Measures for the Issuance and Trading of Corporate Bonds” were revised, abolishing the mandatory provisions on credit ratings for public issuance of corporate bonds. On March 26, 2021, the “Notice on the Implementation of Arrangements for Canceling Compulsory Ratings of Debt Financing Instruments” pointed out that in the issuance process, the mandatory disclosure requirements for facility rating reports would be canceled, and the disclosure requirements for issuer rating reports would be retained. On August 11, 2021, the People's Bank of China decided to pilot the cancellation of the credit rating requirements for the issuance of non-financial enterprise debt financing instruments. The main purpose of the policy canceling the mandatory facility rating in the issuance process is to change the disclosure of facility credit ratings from mandatory to voluntary. Thus, the policy removes the regulatory role in facility credit ratings but, by retaining issuers' credit ratings, it enables the voluntary disclosure of facility credit ratings to provide incremental information.
This paper finds that after the implementation of the mandatory rating policy, the quality of ratings of issuers that retain the facility rating declines, and credit rating quality decreasing is lower when the reputation of the rating agency is high. The heterogeneity analysis shows that the above relationship mainly holds when there is a high degree of competition among rating agencies, the level of customer importance is high, bond issuance is the issuer's initial issuance. Finally, this paper shows that after the implementation of the mandatory facility rating policy, for issuers that retain facility ratings, the inflated credit rating reduces the financing cost of bonds, indicating that the bond market is not fully aware of credit rating inflation, prompting issuers to seek inflated credit ratings.
The results of the paper indicate that, on the one hand, the abolition of the mandatory facility rating policy enhances the degree of competition among rating agencies and the motivation of rating agencies to cater to issuers, and thus reduces the quality of credit ratings in the short term. On the other hand, once the selection of a facility rating is made voluntary, the reputation mechanism of the rating market is conducive to a “market-driven” improvement in credit rating quality in the long run.
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Received: 04 July 2023
Published: 16 July 2024
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