The Credit Ratings Game
AbstractThe collapse of so many AAA-rated structured finance products in 2007-2008 has brought renewed attention to the causes of ratings failures and the conflicts of interest in the Credit Ratings Industry. We provide a model of competition among Credit Ratings Agencies (CRAs) in which there are three possible sources of conflicts: 1) the CRA conflict of interest of understating credit risk to attract more business; 2) the ability of issuers to purchase only the most favorable ratings; and 3) the trusting nature of some investor clienteles who may take ratings at face value. We show that when combined, these give rise to three fundamental equilibrium distortions. First, competition among CRAs can reduce market effciency, as competition facilitates ratings shopping by issuers. Second, CRAs are more prone to inate ratings in boom times, when there are more trusting investors, and when the risks of failure which could damage CRA reputation are lower. Third, the industry practice of tranching of structured products distorts market efficiency as its role is to deceive trusting investors. We argue that regulatory intervention requiring: i) upfront payments for rating services (before CRAs propose a rating to the issuer), ii) mandatory disclosure of any rating produced by CRAs, and iii) oversight of ratings methodology can substantially mitigate ratings ination and promote efficiency.
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Bibliographic InfoPaper provided by Barcelona Graduate School of Economics in its series Working Papers with number 468.
Date of creation: May 2010
Date of revision:
Credit rating agencies; conflicts of interest; ratings shopping;
Other versions of this item:
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- Patrick Bolton & Xavier Freixas & Joel Shapiro, 2009. "The credit ratings game," Economics Working Papers 1149, Department of Economics and Business, Universitat Pompeu Fabra.
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- D43 - Microeconomics - - Market Structure and Pricing - - - Oligopoly and Other Forms of Market Imperfection
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
- L15 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Information and Product Quality
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Blog mentionsAs found by EconAcademics.org, the blog aggregator for Economics research:
- Credit rating inflation and naive investors
by Economic Logician in Economic Logic on 2009-04-03 02:26:00
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