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The Credit Ratings Game

Author

Listed:
  • Patrick Bolton
  • Xavier Freixas
  • Joel Shapiro

Abstract

ThecollapseofsomanyAAA-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 inflate 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 inflation and promote efficiency.

Suggested Citation

  • Patrick Bolton & Xavier Freixas & Joel Shapiro, 2010. "The Credit Ratings Game," Working Papers 468, Barcelona School of Economics.
  • Handle: RePEc:bge:wpaper:468
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    References listed on IDEAS

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    More about this item

    Keywords

    Credit rating agencies; conflicts of interest; ratings shopping;
    All these keywords.

    JEL classification:

    • D43 - Microeconomics - - Market Structure, Pricing, and Design - - - 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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