Standards, Reputational Costs and Market Share: Empirical Evidence from the Credit Rating Industry

Abstract

We examine the joint effect of average default risk and uncertainty on behavior of rating agencies. We find when average default risk rises in the economy standards weaken but a simultaneous increase in uncertainty causes the standards to tighten more. The net effect is the documented conservatism in ratings. A trade-off between short term gains in market share and long term costs to reputation provides a consistent explanation for these findings.