The Credit Ratings Game
The spectacular failure of top-rated structured finance products has brought renewed attention to the conflicts of interest of Credit Rating Agencies (CRAs). We model both the CRA conflict of understating credit risk to attract more business, and the issuer conflict of purchasing only the most favorable ratings (issuer shopping), and examine the effectiveness of a number of proposed regulatory solutions of CRAs. We find that CRAs are more prone to inflate ratings when there is a larger fraction of naive investors in the market who take ratings at face value, or when CRA expected reputation costs are lower. To the extent that in booms the fraction of naive investors is higher, and the reputation risk for CRAs of getting caught understating credit risk is lower, our model predicts that CRAs are more likely to understate credit risk in booms than in recessions. We also show that, due to issuer shopping, competition among CRAs in a duopoly is less efficient (conditional on the same equilibrium CRA rating policy) than having a monopoly CRA, in terms of both total ex-ante surplus and investor surplus. Allowing tranching decreases total surplus further. We argue that regulatory intervention requiring upfront payments for rating services (before CRAs propose a rating to the issuer) combined with mandatory disclosure of any rating produced by CRAs can substantially mitigate the conflicts of interest of both CRAs and issuers.
|Date of creation:||Feb 2009|
|Date of revision:|
|Publication status:||published as Patrick Bolton & Xavier Freixas & Joel Shapiro, 2012. "The Credit Ratings Game," Journal of Finance, American Finance Association, vol. 67(1), pages 85-112, 02.|
|Contact details of provider:|| Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.|
Web page: http://www.nber.org
More information through EDIRC
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.:
- Emmanuel Farhi & Josh Lerner & Jean Tirole, 2013.
"Fear of rejection? Tiered certification and transparency,"
RAND Journal of Economics,
RAND Corporation, vol. 44(4), pages 610-631, December.
- Emmanuel Farhi & Josh Lerner & Jean Tirole, . "Fear of Rejection? Tiered Certification and Transparency," Working Paper 78856, Harvard University OpenScholar.
- Emmanuel Farhi & Josh Lerner & Jean Tirole, 2008. "Fear of Rejection? Tiered Certification and Transparency," NBER Working Papers 14457, National Bureau of Economic Research, Inc.
- Berger, Allen N & Davies, Sally M & Flannery, Mark J, 2000.
"Comparing Market and Supervisory Assessments of Bank Performance: Who Knows What When?,"
Journal of Money, Credit and Banking,
Blackwell Publishing, vol. 32(3), pages 641-67, August.
- Allen N. Berger & Sally M. Davies & Mark J. Flannery, 2000. "Comparing market and supervisory assessments of bank performance: who knows what when?," Proceedings, Federal Reserve Bank of Cleveland, pages 641-670.
- Allen N. Berger & Sally M. Davies & Mark J. Flannery, 1998. "Comparing market and supervisory assessments of bank performance: who knows what when?," Finance and Economics Discussion Series 1998-32, Board of Governors of the Federal Reserve System (U.S.).
- Jean-Jacques Laffont & Jean Tirole, 1993. "A Theory of Incentives in Procurement and Regulation," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262121743, December.
- Jose A. Scheinkman & Wei Xiong, 2003. "Overconfidence and Speculative Bubbles," Journal of Political Economy, University of Chicago Press, vol. 111(6), pages 1183-1219, December.
- Roland Strausz, .
"Honest Certification and the Threat of Capture,"
018, Departmental Working Papers.
- Strausz, Roland, 2004. "Honest Certification and the Threat of Capture," Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems 25, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich.
- Reinhart, Carmen & Levich, Richard & Majoni, Giovanni, 2002. "Ratings, rating agencies and the global financial system: Summary and policy implications," MPRA Paper 13249, University Library of Munich, Germany.
- Benabou, R. & Laroque, G., 1988.
"Using Privileged Information To Manipulate Markets: Insiders, Gurus And Credibility,"
19, Princeton, Woodrow Wilson School - Discussion Paper.
- Roland Benabou & Guy Laroque, 1992. "Using Privileged Information to Manipulate Markets: Insiders, Gurus, and Credibility," The Quarterly Journal of Economics, Oxford University Press, vol. 107(3), pages 921-958.
- Benabou, R. & Laroque, G., 1989. "Using Privileged Information To Manipulate Markets: Insiders, Gurus, And Credibility," Working papers 513, Massachusetts Institute of Technology (MIT), Department of Economics.
- Arnoud W. A. Boot & Todd T. Milbourn & Anjolein Schmeits, 2006.
"Credit Ratings as Coordination Mechanisms,"
Review of Financial Studies,
Society for Financial Studies, vol. 19(1), pages 81-118.
- Arnoud W.A. Boot & Todd T. Milbourn, 2002. "Credit Ratings as Coordination Mechanisms," Tinbergen Institute Discussion Papers 02-058/2, Tinbergen Institute.
- Boot, Arnoud W A & Milbourn, Todd, 2002. "Credit Ratings as Coordination Mechanism," CEPR Discussion Papers 3331, C.E.P.R. Discussion Papers.
- Arnoud W. A. Boot & Todd T. Milbourn, 2002. "Credit Ratings as Coordination Mechanisms," William Davidson Institute Working Papers Series 457, William Davidson Institute at the University of Michigan.
- Pagano, Marco & Volpin, Paolo, 2008.
"Securitization, Transparency and Liquidity,"
09-1, University of Pennsylvania, Wharton School, Weiss Center.
- Marco Pagano & Paolo Volpin, 2008. "Securitization, Transparency and Liquidity," CSEF Working Papers 210, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy, revised 31 Jul 2010.
- Marco Pagano & Paolo Volpin, 2009. "Securitization, Transparency and Liquidity," EIEF Working Papers Series 0907, Einaudi Institute for Economics and Finance (EIEF), revised Feb 2012.
- Pagano, Marco & Volpin, Paolo, 2008. "Securitization, Transparency and Liquidity," CEPR Discussion Papers 7105, C.E.P.R. Discussion Papers.
- Dion Bongaerts & K.J. Martijn Cremers & William N. Goetzmann, 2009.
"Tiebreaker: Certification and Multiple Credit Ratings,"
NBER Working Papers
15331, National Bureau of Economic Research, Inc.
- Dion Bongaerts & K. J. Martijn Cremers & William N. Goetzmann, 2012. "Tiebreaker: Certification and Multiple Credit Ratings," Journal of Finance, American Finance Association, vol. 67(1), pages 113-152, 02.
- Dion Bongaerts & Martijn Cremers & William Goetzmann, 2008. "Tiebreaker: Certification and Multiple Credit Ratings," Yale School of Management Working Papers amz2394, Yale School of Management, revised 01 Sep 2009.
- Bo Becker & Todd Milbourn, 2008. "Reputation and competition: evidence from the credit rating industry," Harvard Business School Working Papers 09-051, Harvard Business School, revised Sep 2010.
- Ashcraft, A. & Goldsmith-Pinkham, P. & Vickery, J., 2010.
"MBS Ratings and the Mortgage Credit Boom,"
2010-89S, Tilburg University, Center for Economic Research.
- Kartik, Navin & Ottaviani, Marco & Squintani, Francesco, 2007. "Credulity, lies, and costly talk," Journal of Economic Theory, Elsevier, vol. 134(1), pages 93-116, May.
- Roman Inderst & Marco Ottaviani, 2009.
"Misselling through Agents,"
American Economic Review,
American Economic Association, vol. 99(3), pages 883-908, June.
- Hand, John R M & Holthausen, Robert W & Leftwich, Richard W, 1992. " The Effect of Bond Rating Agency Announcements on Bond and Stock Prices," Journal of Finance, American Finance Association, vol. 47(2), pages 733-52, June.
- Stolper, Anno, 2009. "Regulation of credit rating agencies," Journal of Banking & Finance, Elsevier, vol. 33(7), pages 1266-1273, July.
- Navin Kartik, 2008.
"Strategic Communication with Lying Costs,"
2008 Meeting Papers
350, Society for Economic Dynamics.
- Adam B. Ashcraft & Til Schuermann, 2008.
"Understanding the securitization of subprime mortgage credit,"
318, Federal Reserve Bank of New York.
- Ashcraft, Adam B. & Schuermann, Til, 2008. "Understanding the Securitization of Subprime Mortgage Credit," Foundations and Trends(R) in Finance, now publishers, vol. 2(3), pages 191-309, June.
- J. Michael Harrison & David M. Kreps, 1978. "Speculative Investor Behavior in a Stock Market with Heterogeneous Expectations," The Quarterly Journal of Economics, Oxford University Press, vol. 92(2), pages 323-336.
- Antoine Faure-Grimaud & Eloïc Peyrache & Lucía Quesada, 2009.
"The ownership of ratings,"
RAND Journal of Economics,
RAND Corporation, vol. 40(2), pages 234-257.
- Morgan, J. & Stocken, P., 1998.
"An Analysis of Stock Recommendations,"
204, Princeton, Woodrow Wilson School - Public and International Affairs.
- Efraim Benmelech & Jennifer Dlugosz, 2009.
"The Alchemy of CDO Credit Ratings,"
NBER Working Papers
14878, National Bureau of Economic Research, Inc.
- repec:rje:randje:v:37:y:2006:1:p:155-175 is not listed on IDEAS
- Efraim Benmelech & Jennifer Dlugosz, 2010.
"The Credit Rating Crisis,"
in: NBER Macroeconomics Annual 2009, Volume 24, pages 161-207
National Bureau of Economic Research, Inc.
- Beatriz Mariano, 2008.
"Do reputational concerns lead to reliable ratings?,"
LSE Research Online Documents on Economics
24433, London School of Economics and Political Science, LSE Library.
- Beatriz Mariano, 2008. "Do Reputational Concerns Lead to Reliable Ratings?," FMG Discussion Papers dp613, Financial Markets Group.
- Marco Ottaviani & Peter Norman Sørensen, 2006. "Reputational cheap talk," RAND Journal of Economics, RAND Corporation, vol. 37(1), pages 155-175, 03.
- Souphala Chomsisengphet & Anthony Pennington-Cross, 2006. "The evolution of the subprime mortgage market," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 31-56.
- Erik Durbin & Ganesh Iyer, 2009. "Corruptible Advice," American Economic Journal: Microeconomics, American Economic Association, vol. 1(2), pages 220-42, August.
- Alessandro Lizzeri, 1999. "Information Revelation and Certification Intermediaries," RAND Journal of Economics, The RAND Corporation, vol. 30(2), pages 214-231, Summer.
- Mathis, Jérôme & McAndrews, James & Rochet, Jean-Charles, 2009. "Rating the raters: Are reputation concerns powerful enough to discipline rating agencies?," Journal of Monetary Economics, Elsevier, vol. 56(5), pages 657-674, July.
- Bolton, Patrick & Freixas, Xavier & Shapiro, Joel, 2007. "Conflicts of interest, information provision, and competition in the financial services industry," Journal of Financial Economics, Elsevier, vol. 85(2), pages 297-330, August.
- Hirshleifer, David & Teoh, Siew Hong, 2003. "Limited attention, information disclosure, and financial reporting," Journal of Accounting and Economics, Elsevier, vol. 36(1-3), pages 337-386, December.
When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:14712. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()
If references are entirely missing, you can add them using this form.