Financial Rating Agencies: Are They Credible? - Insights into the Reporting Incentives of Rating Agencies in Times of Enhanced Risk

Abstract:     
The paper asks if credit rating agencies have incentives to misrepresent their clients' credit quality during an ongoing systemic crisis. Two important elements are essential for a systemic crisis: (1) Investors are not able to distinguish fundamentally healthy debtors from fundamentally unhealthy ones. (2) Investors tend to cumulatively withdraw their funds. Therefore, neither fundamentally healthy nor unhealthy debtors can be expected to survive a creditor's exit.

We model a signaling game that reflects these two assumptions and several others. The game focuses on the creditor's financial pay-offs and the agency's reputational pay-offs. We show that there are no separating equilibria in which agencies report observed credit quality truthfully and creditors make their withdrawal decision contingent on this report.

Depending on the relevant parameters, four different equilibria emerge. In three of these equilibria, rating assignments are always ignored by the creditors. Only in one equilibrium, there is limited transmission of decision-useful information as both players adopt mixed strategies.

Pure strategy equilibria in which rating assignments reflect decision-useful information can develop for a certain scope of parameters if some of the above mentioned assumptions are relaxed, i.e. if fundamentally healthy firms can survive cumulative creditor's withdrawal with positive probability, or if two rating agencies successively evaluate the debtor.

The paper's findings add to the understanding of self-fulfilling prophecy phenomena in financial markets.

Number of Pages in PDF File: 25

Keywords: Rating, rating agencies, systemic risk, reporting incentives, reporting, credit quality, asymmetric information, credit

JEL Classification: D82, F34, G23

Accepted Paper Series