Abstract

http://ssrn.com/abstract=1344694
 
 

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The Credit Ratings Game


Patrick Bolton


Columbia Business School - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Xavier Freixas


Universitat Pompeu Fabra; Centre for Economic Policy Research (CEPR)

Joel D. Shapiro


University of Oxford - Said Business School

February 2009

NBER Working Paper No. w14712

Abstract:     
The spectacular failure of top-rated structured finance products has brought renewed attention to the conflicts of interest of Credit Rating Agencies (CRAs). We model both the CRA conflict of understating credit risk to attract more business, and the issuer conflict of purchasing only the most favorable ratings (issuer shopping), and examine the effectiveness of a number of proposed regulatory solutions of CRAs. We find that CRAs are more prone to inflate ratings when there is a larger fraction of naive investors in the market who take ratings at face value, or when CRA expected reputation costs are lower. To the extent that in booms the fraction of naive investors is higher, and the reputation risk for CRAs of getting caught understating credit risk is lower, our model predicts that CRAs are more likely to understate credit risk in booms than in recessions. We also show that, due to issuer shopping, competition among CRAs in a duopoly is less efficient (conditional on the same equilibrium CRA rating policy) than having a monopoly CRA, in terms of both total ex-ante surplus and investor surplus. Allowing tranching decreases total surplus further. We argue that regulatory intervention requiring upfront payments for rating services (before CRAs propose a rating to the issuer) combined with mandatory disclosure of any rating produced by CRAs can substantially mitigate the conflicts of interest of both CRAs and issuers.

Number of Pages in PDF File: 47

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Date posted: February 17, 2009  

Suggested Citation

Bolton, Patrick and Freixas, Xavier and Shapiro, Joel D., The Credit Ratings Game (February 2009). NBER Working Paper No. w14712. Available at SSRN: http://ssrn.com/abstract=1344694

Contact Information

Patrick Bolton (Contact Author)
Columbia Business School - Department of Economics ( email )
3022 Broadway
New York, NY 10027
United States
HOME PAGE: http://www0.gsb.columbia.edu/faculty/pbolton/

Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
European Corporate Governance Institute (ECGI)
c/o ECARES ULB CP 114
B-1050 Brussels
Belgium
HOME PAGE: http://www.ecgi.org
Xavier Freixas
Universitat Pompeu Fabra ( email )
Ramon Trias Fargas 25-27
Barcelona, 08005
Spain
+34 93 542 2726 (Phone)
+34 93 542 1746 (Fax)
HOME PAGE: http://www.econ.upf.es/~freixas
Centre for Economic Policy Research (CEPR) ( email )
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
HOME PAGE: http://www.econ.upf.es/~freixas/more/personal1.htm
Joel D. Shapiro
University of Oxford - Said Business School ( email )
Park End Street
Oxford, OX1 1HP
Great Britain
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References:  32
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