Credit Ratings and Litigation Risk

Abstract

We develop a model of a credit rating agency in which the rating agency expends due-diligence effort to learn about the issuer's credit risk, and the precision of its rating is predicated both on this effort and the rating agency's a priori unknown ability. We model the communication of ratings as a cheap-talk game. The coarseness of ratings is endogenously solved for. Reputational concerns motivate the rating agency to expend effort to learn more in a setting in which the agency optimally chooses coarse ratings ex ante. With this model in place, we examine the impact of legal liability for "misrating" on the rating agency's behavior. Like reputational concerns, legal liability is a two-edged sword. On the one hand, as the legal penalty for suspected misrating increases, the rating agency expends greater due-diligence effort, holding fixed the number of ratings. On the other hand, higher legal liability induces the rating agency to reduce the number of ratings. If the legal liability increases asymmetrically - higher legal liability only for ratings deemed ex post to be too high - the rating agency responds by increasing its downward bias in ratings. We also discuss other possible implications of recent legislative changes that have increased rating-agency legal liability.

Keywords: Credit Ratings Agencies, Cheap Talk

JEL Classification: G28