Financial Rating Agencies: Are They Credible? – Insights Into The Reporting Incentives Of Rating Agencies In Times Of Enhanced Systemic Risk
AbstractThe paper asks if credit rating agencies have incentives to misrepresent their clients’ credit quality during an ongoing systemic crisis. Two important elements are essential for a systemic crisis: (1) Investors are not able to distinguish fundamentally healthy debtors from fundamentally unhealthy ones. (2) Investors tend to cumulatively withdraw their funds. Therefore, neither fundamentally healthy nor unhealthy debtors can be expected to survive a creditor’s exit. We model a signalling game that reflects these two assumptions and several others. The game focuses on the creditor’s financial pay-offs and the agency’s reputational pay-offs. We show that there are no separating equilibria in which agencies report observed credit quality truthfully and creditors make their withdrawal decision contingent on this report. Depending on the relevant parameters, four different equilibria emerge. In three of these equilibria, rating assignments are always ignored by the creditors. Only in one equilibrium, there is limited transmission of decision-useful information as both players will adopt mixed strategies. Pure strategy equilibria in which rating assignments reflect decision-useful information can develop for a certain scope of parameters if some of the above mentioned assumptions are relaxed, i.e. (1) if fundamentally healthy firms can survive cumulative creditor’s withdrawal with positive probability, or (2) if two rating agencies successively evaluate the debtor. The paper’s findings add to the understanding of self-fulfilling prophecy phenomena in financial markets.
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Bibliographic InfoArticle provided by LMU Munich School of Management in its journal Schmalenbach Business Review.
Volume (Year): 53 (2001)
Issue (Month): 1 (January)
Find related papers by JEL classification:
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- F34 - International Economics - - International Finance - - - International Lending and Debt Problems
- G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
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- Loffler, Gunter, 2005. "Avoiding the rating bounce: why rating agencies are slow to react to new information," Journal of Economic Behavior & Organization, Elsevier, vol. 56(3), pages 365-381, March.
- Bappaditya Mukhopadhyay, 2004. "Moral Hazard with Rating Agency: An Incentive Contracting Approach," Annals of Economics and Finance, Society for AEF, vol. 5(2), pages 313-333, November.
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- Shahzad Uddin & Bernard Gumb & Stephen Kasumba, 2011. "Trying to operationalise typologies of the spectacle: A literature review and a case study," Accounting, Auditing & Accountability Journal, Emerald Group Publishing, vol. 24(3), pages 288-314, April.
- Guttler, Andre & Wahrenburg, Mark, 2007. "The adjustment of credit ratings in advance of defaults," Journal of Banking & Finance, Elsevier, vol. 31(3), pages 751-767, March.
- Mathis, Jérôme & McAndrews, James & Rochet, Jean-Charles, 2009. "Rating the raters: Are reputation concerns powerful enough to discipline rating agencies?," Journal of Monetary Economics, Elsevier, vol. 56(5), pages 657-674, July.
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