Many identify inflated credit ratings as one contributor to the recent financial market turmoil. We develop an equilibrium model of the market for ratings and use it to examine possible origins of and cures for ratings inflation. In the model, asset issuers can shop for ratings -- observe multiple ratings and disclose only the most favorable -- before auctioning their assets. When assets are simple, agencies' ratings are similar and the incentive to ratings shop is low. When assets are sufficiently complex, ratings differ enough that an incentive to shop emerges. Thus, an increase in the complexity of recently-issued securities could create a systematic bias in disclosed ratings, despite the fact that each ratings agency produces an unbiased estimate of the asset's true quality. Increasing competition among agencies would only worsen this problem. Switching to an investor-initiated ratings system alleviates the bias, but could collapse the market for information.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
14761.
Length: Date of creation: Feb 2009 Date of revision: Handle: RePEc:nbr:nberwo:14761
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References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
Ettore Damiano & Hao Li & Wing Suen, 2006.
"Credible Ratings,"
Working Papers
tecipa-219, University of Toronto, Department of Economics.
[Downloadable!]
Other versions:
Damiano, Ettore & Li, Hao & Suen, Wing, 2006.
"Credible Ratings,"
Micro Theory Working Papers
damiano-06-01-17-01-56-45, Microeconomics.ca Website, revised 17 Jan 2006.
[Downloadable!]
James B. Bullard & George W. Evans & Seppo Honkapohja, 2004.
"Near-rational exuberance,"
Working Papers
2004-025, Federal Reserve Bank of St. Louis.
[Downloadable!]
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