In July 2013, Moody’s unexpectedly increased the amount of equity credit speculative-grade firms receive for preferred stock from 50% to 100%. Firms affected by the rule change were suddenly considered less levered by Moody’s, even though their balance sheets did not change. These firms responded by issuing debt to restore the original leverage ratio as defined by Moody’s and growing their assets. The rule change transferred value from debt to equity holders and led to an increase in preferred stock issuance. How rating agencies assess risk thus has a significant causal impact on firms’ financing, investment, and security design decisions.

Theories of competition typically predict a positive relationship between market concentration and prices. However, in loan markets, adverse selection can reverse this relationship as riskier borrowers become more likely to receive funding. Using supervisory data, we show that interest rates, borrower risk, and lending volume are higher in markets with more banks. We also create a novel measure of markup that is orthogonal to borrower risk, and find that, consistent with adverse selection, markups are higher after repeated borrowing relationships. Finally, we use a shock to large banks' lending costs to provide further support for the adverse selection channel.