Rating Agencies Fuelled the Crisis Finance Essay

Not only credit rating has a major influence on capital allocation decisions, it is also a key aspect that managers take into consideration when making capital structures decisions. Indeed, in 2002, the Wall Street Journal indicated that Fiat was focusing on decreasing its debt level since it was "increasingly worried about a possible downgrade of its credit rating". According to Graham and Harvey's findings in 2001, CFOs consider credit ratings as the second most important considerations when they determine the corporation's financial structure. Moreover, it is important to remind the fact that the capital structure decision of a firm, which can be characterized as the allocation of long-term debt and equity in the capital structure used to financed fixed assets, is financial decision of significant important for managers. However, although there is has been a heated debate on the various factors that influence the capital structure of a corporation, there has been few researches that argue that credit ratings is a key component of the process concerning capital structure decision making. Indeed, if Kisgen explained in 2006 that credit ratings have a direct influence on capital structure decisions, his study was based on a sample of American companies for the period from 1986 and 2001. Due to the very active corporate bonds market in the United-States, American data was abundant. In addition, in 2011, Michelsen and Klein analyzed a international sample of companies for the period from 1990 to 2008 and found the same results based on the fact that credit ratings strongly impact the capital structure of corporations. No researcher has yet focused on assessing the relation between credit ratings and the capital structure decision making in European countries. As a result, the research questions on which this study will be based are the following: -Does the corporate credit rating provided by rating agencies have an impact on the capital structure decisions made by management in European countries? -How is this rating reflected in the financial structure of corporations? Does this only affect the firm's leverage level or also the amount of equity? -Does an upgrade have the same influence on the capital structure decision made by management than a downgrade? The two main theories concerning the factors that affect the capital structure decisions of a firm are the trade-off and the pecking order theory. These modern theories have been derived from the work done by Modigliani Miller in 1958, which is based on the fact that a firm's value is not correlated to its leverage. The acknowledgement of the existence of bankruptcy costs and taxes has resulted in the development of the trade-off theory. This theory assumes that a value-maximizing firm will compare the benefits of issuing debt, such as the value of interest tax shields, with the costs of debt such as the direct and indirect costs of bankruptcy in order to determine the optimal capital structure of the company. The pecking-order theory is based on the existence of asymmetric information and argues that firms will usually prefer to use internal funds and equity rather than issuing equity due to asymmetric information costs (Myers, 1984). As a result, this theory does not provide an optimal level of debt: companies will issue debt when investment exceeds internal funds and leverage will decrease when investment is below internal funds. However, the determination of the optimal capital structure of a firm is very complex task for management. Both theories mentioned above do not take into account all relevant factors that explain the capital structure decisions made by a firm's management. Indeed, Graham and Harvey stated in 2001 that 57,1% of CFOs considered that credit ratings had a significance influence on their decisions concerning the optimal gearing level for their firms. For this study, we will use the empirical research method. Within this research framework, we will use the secondary data method. The sample is based of all companies with a credit rating that belong to the STOXX Europe 600 Index. According to Faulkender and Petersen, companies that have a public debt rating issue approximately 78% of outstanding debt. As a result, the sample chosen reflects a large portion of active firms in capital markets. The STOXX Europe 600 Index, derived from the STOXX Europe Total Market Index (TMI), is composed of 600 companies and reflects large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden and the United Kingdom. We will extract two types of secondary data from the Datastream database: -the companies' financial statements extracted from their financial statements for the period from Q1 2000 until Q1 2012. This time period reflects two cycles: the 2000 bullish market in the global capital market thanks to the burst of the dot-com boom as well as two major economic crisis: the 2001 dot com bubble burst and the 2008 financial and economic crisis with the collapse of Lehman's Brothers. -the firms' long term corporate obligations ratings by Moody's that characterizes as "the opinions of the relative credit risk of fixed-income obligations with an original maturity of one year or more and that reflect both the likehood of default and any financial loss suffered in the event of default". (Moody's 2009). The corporate credit rating used in prior work (for example Kisgen, 2006) is the long-term issuer credit rating of S&P. By choosing Moody's long-term corporate obligations ratings, we will be able to assess of there is any discrepancies between the results found using the credit ratings of S&P and those using the ratings of another credit rating agency. We will apply a selection criteria for this sample: -we will exclude from the study companies that have been deleted from the STOXX Europe 600 due to delistings, mergers and takeovers -we will also exclude financial firms such as banks, insurances and investments firms since debt and equity issuances for this category of firms has a different goal than for service or industrial firms, which as been argued by Lasfer in 1995 -we will exclude from the sample any companies which is not characterized by Datastream as an issuer on the corporate bond market -finally, we will exclude companies which are not rated by Moody's from Q1 2000 until Q1 2012 or which financial statements are not available. For this study, we will carry out a methodological approach based on Kisgen (2006) empirical design. In order to assess the fact that a company close to a credit rating downgrade or upgrade will issue less debt compared to equity in order to avoid a downgrade or to maximize its chances to benefit from an upgrade (the CR-CS hypothesis), Kisgen (2006) states that there are three levels of credit rating changes: credit rating change from investment-grade to non-investment grade, the "Broad Ratings change", a "Broad Rating " being a credit category that includes the plus, middle and minus specification of a certain rating (for example, B+, B and B-), and the "Micro Ratings" which are specific ratings that include a plus or a minus modification, if given. For our study, we will only focus on the first two potential credit rating changes since they are the most significant. We will therefore conduct two empirical tests: the Plus or Minus test (POM) to test for a credit rating change from one broad category to another and the Investment Grade vs Speculative Grade test (IGSG) to assess the impact of a change from investment grade to non-investment grade. In both these tests, the same dependent variable will be used to define the capital structure of the firm: it will be reflected by measures of the amount of net debt relative to net equity issued by the firm. Due to the fact that we will extract from Datastream Moody's credit rating at the beginning of the year for each firm, we will use measures of a firm' capital structure for the subsequent 12 months. In addition, we will opt for book values since credit rating agencies often use these variables instead of market values. Moreover, book values are measures that highlight decisions made by the management of a company. In order to make the distinction between corporations that are close to a potential downgrade or upgrade and firms that are not, Kisgen (2006) also introduced dummy variables.

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