Working Paper: NBER ID: w14712
Authors: Patrick Bolton; Xavier Freixas; Joel Shapiro
Abstract: 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.
Keywords: credit ratings; credit rating agencies; issuer shopping; regulatory solutions
JEL Codes: D43; D82; G24; L15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| fraction of naive investors (G11) | likelihood of CRAs inflating ratings (G24) |
| naive investors (G40) | inflated ratings (E31) |
| expected reputation costs (D84) | likelihood of CRAs inflating ratings (G24) |
| market conditions (P42) | likelihood of CRAs understating credit risk (G21) |
| naive investors + lower reputation risks (G24) | likelihood of CRAs understating credit risk during booms (G21) |
| regulatory interventions (G18) | CRA rating accuracy (C52) |