The Effect of a Rating Downgrade on Outstanding Commercial Paper

Diamond (1991) argues that a firm's reputation determines whether it borrows directly or through an intermediary. We test the Diamond model by examining the quantity response of commercial paper issued by bank holding companies to a rating downgrade. From 1986 to 1991, cumulative abnormal declines averaged 6.69 percent in the first two weeks after the downgrade and 11.05 percent in the subsequent 12 weeks. In contrast to commercial paper issued by bank holding companies, large CDs issued by affiliated banks did not change significantly in the period around a downgrade, suggesting that deposit insurance may have removed market discipline from the CD market. THE OBJECTIVE OF THIS study is to test Diamond's (1991) theory of corporate capital structure in which a firm's reputation determines whether it borrows directly or through an intermediary. In Diamond's model, a firm without an established reputation will borrow through, and be monitored by, an intermediary. By building a good reputation, a firm may gain access to the nonintermediated markets, such as the commercial paper market, and, consequently, avoid the cost of monitoring. In the process of maintaining its reputation, a firm may eliminate the conflict of interest between borrowers and lenders about the choice of risk in investment decisions. Such firms have an incentive to maintain their reputation because the reputation itself has become a valuable asset that reduces borrowing costs. In the model, a firm that loses its reputation will find the cost of placing debt directly prohibitively expensive. Using event study methodology, we test the Diamond model by examining the quantity response of commercial paper (CP) to a rating downgrade of the issuing company. We focus on ratings because firms that borrow in the CP market usually have high ratings. In part, these ratings reflect the firms' reputation for selecting safe investments. In the Diamond framework, if credit ratings proxy for reputation, then a rating downgrade may be associated with a decline in the amount of outstanding CP. This change in capital structure may occur relatively rapidly because outstanding CP typically has a