Credit Ratings as Coordination Mechanisms

Abstract:     
In this Paper, we provide a novel rationale for credit ratings. The rationale that we propose is that credit ratings can serve as a coordinating mechanism in situations where multiple equilibria can obtain. We show that credit ratings provide a 'focal point' for firms and their investors. We explore the vital - but previously overlooked - implicit contractual relationship between a credit rating agency and a firm. Credit ratings can help fix the desired equilibrium and as such play an economically meaningful role. Our model provides several empirical predictions and insights regarding the expected price impact of ratings changes, the discreteness in funding cost changes, and the effect of the focus of organizations on the efficacy of credit ratings.

Number of Pages in PDF File: 33

Keywords: Credit ratings, multiple equilibria, coordination

JEL Classification: G23, G24, G32

working papers series