When the working-paper version of our study first circulated in 2021, S&P strongly objected to our interpretation, emphasizing that its index committee operates independently of its ratings business, with the two separated by a “Chinese wall”. According to the company, the index team does not communicate with ratings analysts about firm-level decisions, and therefore, index inclusion cannot be influenced by ratings-related revenue. While we take this claim seriously, the data reveal patterns that are difficult to reconcile with full separation between S&P’s index and ratings divisions.
S&P publishes detailed criteria for index inclusion, including minimum market capitalisation, liquidity, financial viability, and sector representation. Thus, we began with a simple question: How closely did decisions to include firms follow these stated rules? Using data from 1980 to 2018, we found that the published criteria explained no more than 15% of additions to the S&P 500. Many firms that met all the criteria were passed over, while others were admitted despite seeming to fall short.
To be sure, there is nothing inherently wrong with discretion in stock-index construction, and S&P does not claim its methodology is purely mechanical. The index committee is expected to exercise judgment. But whenever discretion is involved, incentives matter.
With this in mind, we examined whether firms that recently purchased an S&P credit rating were more likely to be added to the index. S&P does not publicly disclose its rating fees, but estimates from other rating agencies suggest that they range from a few thousand dollars to several million. After accounting for the published selection criteria, we found a clear pattern: firms that had recently obtained an S&P rating were significantly more likely to gain admission to the S&P 500. For non-member firms, the unconditional likelihood of being added to the index was 15.5%; for firms that had recently purchased an S&P rating, it was 21.4%.
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One possible explanation is that S&P tends to favour fast-growing firms, and that such companies are naturally more likely to issue debt and seek credit ratings. But if that were the whole story, we would expect to see the same pattern among firms that purchased ratings from Moody’s, and we did not. If rating purchases simply reflect firm quality or growth prospects, the effect should not be specific to S&P.
Firms’ behaviour further suggests that they see a link between rating purchases and index inclusion. When mergers among S&P 500 firms create openings for new additions, large non-member firms disproportionately increase their purchases of S&P ratings. Conversely, after a 2002 rule change that made foreign firms ineligible for inclusion, non-US firms listed on US exchanges sharply reduced their purchases of S&P ratings relative to Moody’s. The implication is clear: when the prize disappears, so does demand. Taken together, these patterns suggest that firms believe purchasing S&P ratings increases their chances of joining the index.
What about another, more innocent explanation? S&P learns useful information during the ratings process, which helps it decide whether firms belong in the index. In that case, the correlation we observed between rating purchases and subsequent inclusion reflects improved information from the rating process rather than business incentives.
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But this explanation is difficult to sustain. For starters, if index-addition decisions rely on non-public information obtained through the ratings process, that would mark a departure from S&P’s published methodology, which does not indicate that private ratings information is used in index decisions.
Moreover, such information-sharing would seem at odds with S&P’s public statements that the index committee and ratings department operate independently and do not exchange firm-specific data. In addition, the information uncovered during the rating process could just as easily lower a firm’s chances of inclusion as raise them.
Lastly, when we looked at how companies performed after joining the S&P 500, we found no evidence that discretionary additions — including those associated with recent rating purchases — systematically outperformed rule-based additions or even firms that met the criteria but were passed over. In other words, discretion does not appear to lead to better outcomes.
Whether or not S&P 500 membership is literally for sale, the evidence suggests that firms behave as if it might be. And when companies believe that paying for ratings can improve their odds of inclusion in the index, the credibility of the admission process is at risk.— © Project Syndicate
Shang-Jin Wei, a former chief economist at the Asian Development Bank, is Professor of Finance and Economics at Columbia Business School and Columbia University’s School of International and Public Affairs.
