Working Paper: CEPR ID: DP8156
Authors: Heski Bar-Isaac; Joel Shapiro
Abstract: The reduced accuracy of credit ratings on structured finance products in the boom just preceding the financial crisis has prompted investigation into the business of Credit Rating Agencies (CRAs). While CRAs have long held that their behavior is disciplined by reputational concerns, the value of reputation depends on economic fundamentals that vary over the business cycle. These include income from fees, default probabilities for the securities rated, competition in the labor market for analysts, and expectations about the future. We analyze a dynamic model of ratings where reputation is endogenous and the market environment may vary over time. We find that a CRA is more likely to issue less accurate ratings in boom times than during recessionary periods. Persistence in economic conditions can diminish our results, while mean reversion exacerbates them. Finally, we demonstrate that competition among CRAs yields similar qualitative results.
Keywords: credit rating agencies; ratings accuracy; reputation
JEL Codes: G24; L14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Economic cycle (E32) | Ratings quality (L15) |
| Boom periods (E32) | Less accurate ratings (C52) |
| Higher costs for CRAs (G24) | Ratings quality (L15) |
| Less effective monitoring (E63) | Ratings quality (L15) |
| Higher revenues during booms (E32) | Ratings quality (L15) |
| Competition among CRAs (G24) | Ratings quality (L15) |