Working Paper: NBER ID: w31303
Authors: Harold L. 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 consider both an investor-pays and an issuer-pays set-ups and show that if the investor-pays version can overcome the free-rider problem it is efficient, and otherwise leads to under-provision of information; while if the issuer-pays can force disclosure, it is efficient, but otherwise it leads to less revealing information because of the systematic distortion in revealed information along with over-investment in information. We show that in both these arrangements credit ratings have value in equilibrium and how reputation insures that, in equilibrium, ratings will reflect sound assessments of credit worthiness. 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.
Keywords: credit rating agencies; information acquisition; financial markets; regulation
JEL Codes: D80; G14; G18
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Investor-pays model overcomes freerider problem (G24) | appropriate information provision (D83) |
| Freerider problem not resolved (H40) | under-provision of information (D83) |
| Issuer-pays model requires truthful information disclosure (G24) | efficient model (C51) |
| Issuers can choose what information to reveal (G24) | excessive information generation (D83) |
| Regulatory reliance on ratings (G18) | distorted quality of ratings (L15) |
| Shift from investor-pays to issuer-pays models (G24) | conflicts of interest (G34) |
| Conflicts of interest (G34) | compromised objectivity of credit ratings (G24) |