Asian Review of Financial Research

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The Effect of Credit Rating Downgrade on Financial Policies of Incumbent Firms ×
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Asian Review of Financial Research Vol.33 No.3 pp.377-402
The Effect of Credit Rating Downgrade on Financial Policies of Incumbent Firms
Youngjoo Lee1†
1 서강대학교 경영대학 부교수
Jin Q Jeon1†
1 동국대학교 경영대학 부교수
Key Words : 신용등급; 경쟁효과; 전이효과; 현금보유성향; 자본적 지출;Creding rating; Competition effect; Contagion effect; Cash holdings; Capital expenditures

Abstract

This paper analyzes the impact of a downgrade in corporate credit rating on the financial policies of competitors in the same industry. Most previous research on credit ratings provides a model for estimating credit ratings based on firms' financial characteristics; the pattern of stock or bond returns after credit rating changes; the competitiveness of the credit rating market; or the reliability of ratings before or after the global financial crisis. Credit rating adjustment, however, is under-researched. This important event provides investors and other stakeholders with information on firm valuation and has a direct impact on financing costs, thus profoundly affecting firm growth and financial stability. We investigate the following two conflicting hypotheses. First, downgrading the credit rating of a particular firm may act as an industry-wide negative signal to the market. This will affect the investment returns of competing firms, which may lead competing firms within the industry to be more conservative in their financial policies, due to concern about the risk of a corresponding downgrade in their credit ratings. The second hypothesis is that downgrading the credit rating of a particular firm may increase the financial costs of the firm and thereby reduce the intensity of competition in the industry. This may lower the growth potential of the firm, which competitors can use as an opportunity to increase their investment by implementing a more aggressive financial policy. We call the effect described in the former hypothesis the “contagion effect,” and that described in the latter the “competition effect.” To test these conflicting hypotheses, we obtain all of the bond rating data of firms listed on the Korea Composite Stock Price Index from 2005 to 2018 and examine the changes in their corporate financial policy in three dimensions: cash holdings, capital expenditure, and long-term leverage. Studies document that cashing holdings are affected by market risk as well as the risk associated with firms' business activities. A change in credit ratings can also affect the method of raising funds. Increasing leverage leads to a decline in liquidity due to high interest payments. In addition, an increase in financing costs due to an increase in firm default risk tends to limit external financing for future investments. In addition, the impact of credit rating adjustments within an industry may vary depending on the competitive position of a firm experiencing a credit rating downgrade, the competitive position of competing firms, and the degree of competition in the industry. Firms in a less competitive industry can more aggressively use opportunities to implement financial policies, while firms in a more competitive industry may have to make more aggressive investments to survive. Our empirical results show that a credit rating downgrade tends to lead firms in the same industry to maintain a conservative financial policy by increasing their cash holdings and decreasing their capital expenditure and long leverage. However, this phenomenon varies across competitive positions within an industry. Firms taking a strong competitive position in the top 25th percentile of revenue are more likely to maintain a conservative financial policy when a rating downgrade occurs in their industry. This relationship is more significant when firms whose ratings have been downgraded are in the same competitive position, i.e., in the top 25th percentile of revenue. The results are consistent with the contagion effect hypothesis. In contrast, firms taking a weak competitive position, i.e., in the bottom 25th percentile of revenue, tend to maintain an aggressive financial policy. This relationship is also more significant, both statistically and economically, if firms whose credit ratings have been downgraded are in the weakly competitive group, i.e., the bottom 25th percentile of revenue. This finding is consistent with the competition effect hypothesis. We also find that the results above, linking the contagion effect with highly competitive firms and the competitive effect with weakly competitive firms, are more significant when the industry is more competitive, as measured by the Herfindahl-Hirschman Index. Most existing studies of credit ratings analyze credit rating prediction models, the stock and bond yield behaviors of firms with rating changes, or the reliability of credit ratings and related systems. This paper contributes to the credit rating literature by examining the effects of credit rating changes on the financial policies of competing firms. It also makes an important contribution to the literature on corporate finance, specifically corporate capital structure theory, by providing evidence that changes to firms' credit ratings are a key determinant of the financial and investment policies of competing firms in the industry. In addition, the finding that risk-seeking behavior varies with the competitive position of a firm may have important policy implications for relevant financial authorities seeking to enhance firms' financial soundness.
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