Third-party certification in new issues of corporate tax-exempt bonds: standby letter of credit and bond rating interaction

Financial Management (Financial Management Association), Spring, 1996 by Roger D. Stover

B. Joint Certification Influence of Bank Issuance of Standby Letter of Credit and Associated Credit Rating

Prior studies suggest that, separately, the lending and the rating decisions may affect the market's reception, particularly to security offerings by relatively unknown firms. However, their joint effect has not been empirically examined. Such a combined effect is the focus of this paper, recognizing that the bank's decision to issue a standby letter of credit is analogous to making a decision to lend. I analyze the relative merits of the two certifying influences.

In developing their model for certification of initial public offerings involving venture capital firms, Megginson and Weiss (1991) established three criteria for certification to be credible to outside investors. First, the certifying agent must have, in their terminology, reputational capital at stake in the certification activity. If the agent suggested a fair market value in excess of the offering price, it would suffer a loss of future relationships because of its reduced trustworthiness in the eyes of current and potential clients. Second, this loss in reputational capital must exceed the gain that is possible from false certification. Third, the services provided by the agent must be costly to the firm and this cost must be related to the asymmetric information associated with the issuing firm.

This set of criteria can also be applied to the agents involved in the issuance of corporate tax-exempt debt backed by a standby letter of credit. Rating agencies rate such bond offerings based primarily on the irrevocable commitment of the bank issuing the letter of credit. In a letter to a bank issuing standby letters of credit, Standard & Poor's stated:(1)

With the legal issues addressed, our rating reflects the ability and assumes the willingness of the bank to honor its irrevocable commitment. We believe that in issuing the letter of credit, the bank has made a credit judgment of the borrower, has decided to irrevocably commit funds, and has set its compensation level according to the risk perceived. We consider the bank's willingness to honor this commitment in a timely and full fashion to be as strong as its willingness to honor and repay other direct forms of indebtedness such as commercial paper and capital market financings that we rate. We would expect the bank to vigorously seek to make immediate payment in order to maintain the integrity of, and confidence in, its letter of credit instruments.

This letter illustrates that the Megginson and Weiss criteria for a creditable certifying agent are principally met by banks issuing standby letters of credit. The overall tone of the letter suggests evidence of criterion one - the risk of reputational capital. Standard & Poor's states that its rating depends on the bank's willingness to honor the letter of credit and, as an indication of the cost of noncompliance, notes that its ratings of the bank's liabilities would also be affected.(2) A failure to fund the letter of credit commitment would be costly to the bank not only in terms of future letter of credit business but also, potentially, the direct costs of its own financing. This is a strong indication that the present value of future business and external financing would likely outweigh any value in fees derived from an ultimately unfunded standby letter of credit. Finally, the rating is almost exclusively tied to the credibility of the bank's guarantee. This provides evidence of meeting the third Megginson and Weiss (1991) criterion: The bank is uniquely providing the due diligence for the credit-enhanced bond offerings and likely charging fees that vary according to the quality of the customer.