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Rating the raters: Are reputation concerns powerful enough to discipline rating agencies?

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  • Mathis, Jérôme
  • McAndrews, James
  • Rochet, Jean-Charles

Abstract

Credit rating agencies (CRAs) are accused of bearing a strong responsibility for contributing to the subprime crisis by having been deliberately too lax in the ratings of some structured products. In response to this accusation, CRAs argue that such an attitude would be too dangerous for them, since their reputation is at stake. The objective of this article is to examine the validity of this argument within a formal model: Are reputation concerns sufficient to discipline rating agencies? We show that the reputation argument only works when a sufficiency large fraction of the CRA income comes from other sources than rating complex products. By contrast when rating complex products becomes a major source of income for the CRA, we show that it is always too lax with a positive probability and inflates ratings with probability one when its reputation is good enough. We provide some empirical support for this prediction, by showing that ceteris paribus, the proportion of subprime residential mortgage-backed securities (RMBS) that were rated AAA by the three main CRAs indeed increased over the last eight years. We analyze the policy implications of our findings and advocate for a new business model of CRAs that we call the platform-pays model.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 56 (2009)
Issue (Month): 5 (July)
Pages: 657-674

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Handle: RePEc:eee:moneco:v:56:y:2009:i:5:p:657-674

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Web page: http://www.elsevier.com/locate/inca/505566

Related research

Keywords: Credit rating agencies Conflicts of interest Reputation Repeated games;

References

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  1. Patrick Bolton & Xavier Freixas & Joel Shapiro, 2010. "The Credit Ratings Game," Working Papers 468, Barcelona Graduate School of Economics.
  2. Stephen Morris, 2001. "Political Correctness," Journal of Political Economy, University of Chicago Press, vol. 109(2), pages 231-265, April.
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  9. Sobel, Joel, 1985. "A Theory of Credibility," Review of Economic Studies, Wiley Blackwell, vol. 52(4), pages 557-73, October.
  10. Alessandro Lizzeri, 1999. "Information Revelation and Certification Intermediaries," RAND Journal of Economics, The RAND Corporation, vol. 30(2), pages 214-231, Summer.
  11. Benabou, R. & Laroque, G., 1989. "Using Privileged Information To Manipulate Markets: Insiders, Gurus, And Credibility," Working papers 513, Massachusetts Institute of Technology (MIT), Department of Economics.
  12. Mailath, George J. & Samuelson, Larry, 2006. "Repeated Games and Reputations: Long-Run Relationships," OUP Catalogue, Oxford University Press, number 9780195300796.
  13. Christoph Kuhner, 2001. "Financial Rating Agencies: Are They Credible? – Insights Into The Reporting Incentives Of Rating Agencies In Times Of Enhanced Systemic Risk," Schmalenbach Business Review (sbr), LMU Munich School of Management, vol. 53(1), pages 2-26, January.
  14. Charles Goodhart, 2008. "The Regulatory Response to the Financial Crisis," FMG Special Papers sp177, Financial Markets Group.
  15. Perotti, Enrico C & Suarez, Javier, 2001. "Last Bank Standing: What Do I Gain if You Fail?," CEPR Discussion Papers 2933, C.E.P.R. Discussion Papers.
  16. Carlson Mark & Hale Galina B, 2006. "Rating Agencies and Sovereign Debt Rollover," The B.E. Journal of Macroeconomics, De Gruyter, vol. 6(2), pages 1-32, September.
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