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Livin' On The Edge With Ratings: Liquidity, Efficiency And Stability

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  • Jonathan Chiu
  • Thorsten V. Koeppl

Abstract

We look at the role of credit ratings when assets are issued in a primary market and sold by dealers into a secondary, over-the-counter market in order to study regulatory proposals for rating agencies. Credit ratings are used to overcome a lemons problem. When the lemons problem is moderate, ratings are used to screen issuers, but are inefficiently inaccurate. Hence, too many lemons are issued in order for dealers to profit from rate shopping where low rating standards lead to high volume, but fragile trading in the secondary market. This inefficiency arises from dealers not properly taking into account the informational rents paid indirectly by investors in the secondary market to primary issuers. We use our framework to show that in-house ratings by investors or competition in the secondary market can lead to more accurate ratings and more stable trading, while promoting in-house ratings by dealers and competition among rating agencies are ineffective. Holding dealers liable or having investors pay for accurate ratings ex-post can also improve efficiency and stability.

Suggested Citation

  • Jonathan Chiu & Thorsten V. Koeppl, 2014. "Livin' On The Edge With Ratings: Liquidity, Efficiency And Stability," Working Paper 1335, Economics Department, Queen's University.
    • Handle: RePEc:qed:wpaper:1335
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    File URL: https://www.econ.queensu.ca/sites/econ.queensu.ca/files/wpaper/qed_wp_1335.pdf
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    References listed on IDEAS

    as
    1. Jeon, Doh-Shin & Lovo, Stefano, 2013. "Credit rating industry: A helicopter tour of stylized facts and recent theories," International Journal of Industrial Organization, Elsevier, vol. 31(5), pages 643-651.
    2. 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.
    3. Patrick Bolton & Xavier Freixas & Joel Shapiro, 2012. "The Credit Ratings Game," Journal of Finance, American Finance Association, vol. 67(1), pages 85-112, February.
    4. Bar-Isaac, Heski & Shapiro, Joel, 2013. "Ratings quality over the business cycle," Journal of Financial Economics, Elsevier, vol. 108(1), pages 62-78.
    5. Becker, Bo & Milbourn, Todd, 2011. "How did increased competition affect credit ratings?," Journal of Financial Economics, Elsevier, vol. 101(3), pages 493-514, September.
    6. Thorsten Koeppl & Jonathan Chiu, 2013. "Trading Dynamics With Adverse Selection and Search," 2013 Meeting Papers 201, Society for Economic Dynamics.
    7. Jonathan Katz & Emanuel Salinas & Constantinos Stephanou, 2009. "Credit Rating Agencies," World Bank Publications - Reports 10227, The World Bank Group.
    8. 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.
    9. George A. Akerlof, 1970. "The Market for "Lemons": Quality Uncertainty and the Market Mechanism," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 84(3), pages 488-500.
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    Cited by:

    1. José Jorge, 2016. "Sovereign Ratings and Investor Behavior," CEF.UP Working Papers 1601, Universidade do Porto, Faculdade de Economia do Porto.

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    More about this item

    Keywords

    Ratings; Dealers; Liquidity; Financial Stability;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation

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