Rating Agency Fees: Pay to Play in Public Finance?

This article investigates whether conflicts of interest distort credit ratings in the U.S. municipal bond market, focusing on the relationship between credit rating levels and rating agency fees. Using a unique dataset from Texas municipal bond issuers that includes actual fees paid to credit rating agencies (CRAs) Moody’s, Standard & Poor’s, and Fitch, the study finds that issuers paying higher-than-expected fees receive more favorable credit ratings, controlling for credit risk and issue complexity. This effect is particularly pronounced among uninsured bonds issued by municipalities that lost access to AAA-rated bond insurance following the 2008 financial crisis, suggesting a substitution between insurers and CRAs as certification agents. Additional analyses show that subsequent ratings tend to be more favorable than initial ratings, consistent with rating agencies catering to issuers to secure future business. Despite these distortions, municipal bond markets do not appear to price the inflated ratings differently, implying real costs to taxpayers and investors in this largely retail-dominated market. The authors propose enhanced fee disclosure requirements as a potential policy remedy to mitigate conflicts of interest in credit rating practices.