Working Paper: NBER ID: w14761
Authors: Vasiliki Skreta; Laura Veldkamp
Abstract: Many identify inflated credit ratings as one contributor to the recent financial market turmoil. We develop an equilibrium model of the market for ratings and use it to examine possible origins of and cures for ratings inflation. In the model, asset issuers can shop for ratings -- observe multiple ratings and disclose only the most favorable -- before auctioning their assets. When assets are simple, agencies' ratings are similar and the incentive to ratings shop is low. When assets are sufficiently complex, ratings differ enough that an incentive to shop emerges. Thus, an increase in the complexity of recently-issued securities could create a systematic bias in disclosed ratings, despite the fact that each ratings agency produces an unbiased estimate of the asset's true quality. Increasing competition among agencies would only worsen this problem. Switching to an investor-initiated ratings system alleviates the bias, but could collapse the market for information.
Keywords: ratings inflation; asset complexity; ratings shopping; financial crisis
JEL Codes: D02; D53; D8; G01; G24
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Asset Complexity (G19) | Ratings Shopping (L81) |
| Ratings Shopping (L81) | Asset Complexity (G19) |
| Asset Complexity (G19) | Ratings Inflation (E31) |
| Ratings Shopping (L81) | Ratings Inflation (E31) |
| Asset Complexity + Ratings Shopping (G19) | Ratings Inflation (E31) |