Working Paper: CEPR ID: DP3331
Authors: Arnoud W. A. Boot; Todd Milbourn
Abstract: In this Paper, we provide a novel rationale for credit ratings. The rationale that we propose is that credit ratings can serve as a coordinating mechanism in situations where multiple equilibria can obtain. We show that credit ratings provide a ?focal point? for firms and their investors. We explore the vital ? but previously overlooked ? implicit contractual relationship between a credit rating agency and a firm. Credit ratings can help fix the desired equilibrium and as such play an economically meaningful role. Our model provides several empirical predictions and insights regarding the expected price impact of ratings changes, the discreteness in funding cost changes, and the effect of the focus of organizations on the efficacy of credit ratings.
Keywords: Coordination; Credit Ratings; Multiple Equilibria
JEL Codes: G23; G24; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| credit ratings (G24) | investor beliefs (G41) |
| investor beliefs (G41) | firm behavior (D21) |
| credit ratings (G24) | firm behavior (D21) |
| firm behavior (D21) | funding costs (G32) |
| credit ratings (G24) | funding costs (G32) |
| credit ratings (G24) | stock prices (G12) |
| downgrades (Y40) | stock prices (G12) |