Working Paper: NBER ID: w19972
Authors: Harold Cole; Thomas F. Cooley
Abstract: For decades credit rating agencies were viewed as trusted arbiters of creditworthiness and their ratings as important tools for managing risk. The common narrative is that the value of ratings was compromised by the evolution of the industry to a form where issuers pay for ratings. In this paper we show how credit ratings have value in equilibrium and how reputation insures that, in equilibrium, ratings will reflect sound assessments of credit worthiness. There will always be an information distortion because of the fact that purchasers of ratings need not reveal them. We argue that regulatory reliance on ratings and the increasing importance of risk-weighted capital in prudential regulation have more likely contributed to distorted ratings than the matter of who pays for them. In this respect, much of the regulatory obsession with the conflict created by issuers paying for ratings is a distraction.
Keywords: Credit Ratings; Financial Regulation; Market Dynamics
JEL Codes: G1; G24
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| regulatory reliance on ratings (G24) | distortion of ratings (H31) |
| reputation of rating agencies (G24) | accuracy of credit ratings (G24) |
| regulatory practices (G38) | distortion of ratings (H31) |
| issuer-pays model (G24) | distortion of ratings (H31) |
| regulatory practices + market demand for safe assets (G18) | decline in trustworthiness of ratings (G24) |
| information distortion (D83) | perceived value of ratings (D46) |