Did Government Regulations Lower Credit Rating Quality?

SEC regulations in 1975 gave select ratings agencies increased market power by increasing barriers to entry and reliance on ratings for regulations. We test whether these regulations led to lower ratings quality. We find that defaults and negative financial changes are more likely for firms given the same rating if the rating was assigned after the SEC action compared to before. Further, firms initially rated Baa post-regulations are 19% more likely to be negatively downgraded to speculative grade than firms rated Baa pre-regulations. These results indicate that the market power derived from the SEC led to ratings inflation.

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