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The Credit Ratings Game

Patrick Bolton, Xavier Freixas () and Joel Shapiro

No 468, Working Papers from Barcelona Graduate School of Economics

Abstract: ThecollapseofsomanyAAA-rated structured finance products in 2007-2008 has brought renewed attention to the causes of ratings failures and the conflicts of interest in the Credit Ratings Industry. We provide a model of competition among Credit Ratings Agencies (CRAs) in which there are three possible sources of conflicts: 1) the CRA conflict of interest of understating credit risk to attract more business; 2) the ability of issuers to purchase only the most favorable ratings; and 3) the trusting nature of some investor clienteles who may take ratings at face value. We show that when combined, these give rise to three fundamental equilibrium distortions. First, competition among CRAs can reduce market effciency, as competition facilitates ratings shopping by issuers. Second, CRAs are more prone to inflate ratings in boom times, when there are more trusting investors, and when the risks of failure which could damage CRA reputation are lower. Third, the industry practice of tranching of structured products distorts market efficiency as its role is to deceive trusting investors. We argue that regulatory intervention requiring: i) upfront payments for rating services (before CRAs propose a rating to the issuer), ii) mandatory disclosure of any rating produced by CRAs, and iii) oversight of ratings methodology can substantially mitigate ratings inflation and promote efficiency.

Keywords: Credit rating agencies; conflicts of interest; ratings shopping (search for similar items in EconPapers)
JEL-codes: D43 D82 G24 L15 (search for similar items in EconPapers)
Date: 2010-05
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Related works:
Journal Article: The Credit Ratings Game (2012) Downloads
Working Paper: The credit ratings game (2010) Downloads
Working Paper: The Credit Ratings Game (2009) Downloads
Working Paper: The credit ratings game (2009) Downloads
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