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Credible ratings

Author

Listed:
  • Damiano, Ettore

    () (Department of Economics, University of Toronto)

  • Li, Hao

    () (Department of Economics, University of Toronto)

  • Suen, Wing

    () (School of Economics and Finance, University of Hong Kong)

Abstract

This paper considers a model of a rating agency with multiple clients, in which each client has a separate market that forms a belief about the quality of the client after the agency issues a rating. When the clients are rated separately (individual rating), the credibility of a good rating in an inflationary equilibrium of the signaling game is limited by the incentive of the agency to exaggerate the quality of the client. In centralized rating, the agency rates all clients together and shares the rating information among all markets. This allows the agency to coordinate the ratings and achieve a higher average level of credibility for its good ratings than in individual rating. In decentralized rating, the ratings are again shared among all markets, but each client is rated by a self-interested rater of the agency with no access to the quality information of other clients. When the underlying qualities of the clients are correlated, decentralized rating leads to a smaller degree of rating inflation and hence a greater level of credibility than in individual rating. Comparing centralized rating with decentralized rating, we find that centralized rating dominates decentralized rating for the agency when the underlying qualities are weakly correlated, but the reverse holds when the qualities are strongly correlated.

Suggested Citation

  • Damiano, Ettore & Li, Hao & Suen, Wing, 2008. "Credible ratings," Theoretical Economics, Econometric Society, vol. 3(3), September.
  • Handle: RePEc:the:publsh:370
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    References listed on IDEAS

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    Cited by:

    1. Mariano, Beatriz, 2012. "Market power and reputational concerns in the ratings industry," Journal of Banking & Finance, Elsevier, vol. 36(6), pages 1616-1626.
    2. Yun Wang & Yilan Xu, 2015. "Race to the Top: Credit Rating Bias from Competition," WISE Working Papers 2015-05-12, Wang Yanan Institute for Studies in Economics (WISE), Xiamen University, revised 13 May 2015.
    3. Skreta, Vasiliki & Veldkamp, Laura, 2009. "Ratings shopping and asset complexity: A theory of ratings inflation," Journal of Monetary Economics, Elsevier, vol. 56(5), pages 678-695, July.
    4. Ehlers, Tim & Schwager, Robert, 2012. "Honest Grading, Grade Inflation and Reputation," Annual Conference 2012 (Goettingen): New Approaches and Challenges for the Labor Market of the 21st Century 62051, Verein für Socialpolitik / German Economic Association.
    5. Efraim Benmelech & Jennifer Dlugosz, 2010. "The Credit Rating Crisis," NBER Chapters,in: NBER Macroeconomics Annual 2009, Volume 24, pages 161-207 National Bureau of Economic Research, Inc.
    6. repec:got:cegedp:143 is not listed on IDEAS
    7. Ehlers, Tim & Schwager, Robert, 2012. "Honest grading, grade inflation and reputation," Center for European, Governance and Economic Development Research Discussion Papers 143, University of Goettingen, Department of Economics.

    More about this item

    Keywords

    Signaling; credibility; individual rating; centralized rating; decentralized rating;

    JEL classification:

    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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