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Credit Rating Inflation and Firms' Investments

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  • ITAY GOLDSTEIN
  • CHONG HUANG

Abstract

We analyze credit rating effects on firm investments in a rational bond financing game that features a feedback loop. The credit rating agency (CRA) inflates the rating, providing a biased but informative signal to creditors. Creditors' response to the rating affects the firm's investment decision and thus its credit quality, which is reflected in the rating. The CRA might reduce ex ante economic efficiency, which results solely from its strategic effect: the CRA assigns more firms high ratings and allows them to gamble for resurrection. We derive empirical predictions on the determinants of rating standards and inflation and discuss policy implications.

Suggested Citation

  • Itay Goldstein & Chong Huang, 2020. "Credit Rating Inflation and Firms' Investments," Journal of Finance, American Finance Association, vol. 75(6), pages 2929-2972, December.
    • Handle: RePEc:bla:jfinan:v:75:y:2020:i:6:p:2929-2972
    DOI: 10.1111/jofi.12961
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    5. Jordan Martel & Edward Dickersin Van Wesep & Robert Van Wesep, 2022. "Ratings and Cooperative Information Transmission," Management Science, INFORMS, vol. 68(12), pages 9175-9197, December.

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