The Economic Function of Credit Rating Agencies and Watchlists

Credit rating agencies (CRAs) not only provide credit ratings, but also offer credit rating watchlists to supplement credit ratings. Watchlists provide information on future credit rating changes, which credit ratings alone do not deliver. However, research on watchlists has received little attention from academics. This paper examines the economic role of the watchlist from two non-exclusive perspectives: information delivery and implicit contracting. The information delivery argument suggests that the watchlist is a channel to satisfy investor demand for timely and stable information about the credit risk of firms. On the other hand, the implicit contract argument suggests that, through the watchlist placement, CRAs implicitly induce firms to take remedial actions which are required to avoid rating downgrades. We find that firms with more investor demand for information are more likely to be placed on the watchlist. In addition, the market reactions to watch-preceded downgrades and direct downgrades do not differ. The post-downgrade recovery effect between watch-preceded owngrades and direct downgrades is not significantly different as well. Overall, the results imply that the information delivery argument prevails over the implicit contact argument. This suggests that CRAs use the watchlist to enhance their role as information intermediaries rather than developing an active monitoring role.