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Rating deflation versus inflation: On procyclical credit ratings

Author

Listed:
  • Yao, Zhiyong
  • Gu, Dingwei
  • Chen, Yongmin

Abstract

This article provides a theoretical analysis to reconcile the controversy between rating deflation versus inflation. In our model, the credit rating agency trades off between the current incomes paid by the issuer upon receiving a favorable rating and the future reputation costs. We show that both rating deflation and rating inflation can occur in equilibrium. Furthermore, credit ratings are procyclical since the probability of default is higher and thus the reputation costs are higher during recessions than during booms.

Suggested Citation

  • Yao, Zhiyong & Gu, Dingwei & Chen, Yongmin, 2017. "Rating deflation versus inflation: On procyclical credit ratings," Pacific-Basin Finance Journal, Elsevier, vol. 41(C), pages 46-64.
    • Handle: RePEc:eee:pacfin:v:41:y:2017:i:c:p:46-64
    DOI: 10.1016/j.pacfin.2016.12.003
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    References listed on IDEAS

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    More about this item

    Keywords

    Credit rating agencies; Rating deflation; Rating inflation; Business cycles;
    All these keywords.

    JEL classification:

    • C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
    • 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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