Feedback Effects of Credit Ratings

Gustavo Manso
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Gustavo Manso: MIT

No 1338, 2011 Meeting Papers from Society for Economic Dynamics

Abstract: Rating agencies are often criticized for being biased in favor of borrowers, for being too slow to downgrade following credit quality deterioration, and for being oligopolists. Based on a model that takes into account the feedback effects of credit ratings, I show that: (i) a rating agency should focus not only on the accuracy of its ratings but also on the effects of its ratings on the probability of survival of the borrower; (ii) even when a rating agency pursues an accurate rating policy, multi-notch downgrades or immediate default may occur in response to small shocks to fundamentals; (iii) increased competition between rating agencies can lead to rating downgrades, increasing default frequency and reducing welfare.

Date: 2011
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