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The Economics of Solicited and Unsolicited Credit Ratings

Review of Financial Studies, Forthcoming

51 Pages Posted: 17 Mar 2010 Last revised: 22 Oct 2013

Paolo Fulghieri

University of North Carolina Kenan-Flagler Business School; European Corporate Governance Institute (ECGI)

Günter Strobl

Frankfurt School of Finance & Management

Han Xia

University of Texas at Dallas - Naveen Jindal School of Management

Date Written: June 26, 2013

Abstract

This paper develops a dynamic rational expectations model of the credit rating process, incorporating three critical elements of this industry: (i) the rating agencies' ability to misreport the issuer's credit quality, (ii) their ability to issue unsolicited ratings, and (iii) their reputational concerns. We analyze the incentives of credit rating agencies to issue unsolicited credit ratings and the effects of this practice on the agencies' rating strategies. We find that the issuance of unfavorable unsolicited credit ratings enables rating agencies to extract higher fees from issuers by credibly threatening to punish those that refuse to acquire a rating. Also, issuing unfavorable unsolicited ratings increases the rating agencies' reputation by demonstrating to investors that they resist the temptation to issue inflated ratings. In equilibrium, unsolicited credit ratings are lower than solicited ratings, because all favorable ratings are solicited; however, they do not have a downward bias. We show that, under certain conditions, a credit rating system that incorporates unsolicited ratings leads to more stringent rating standards.

Keywords: Credit rating agencies, Unsolicited credit ratings, Reputation

JEL Classification: D82, G24

Suggested Citation

Fulghieri, Paolo and Strobl, Günter and Xia, Han, The Economics of Solicited and Unsolicited Credit Ratings (June 26, 2013). Review of Financial Studies, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1572059 or http://dx.doi.org/10.2139/ssrn.1572059

Paolo Fulghieri (Contact Author)

University of North Carolina Kenan-Flagler Business School ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

Günter Strobl

Frankfurt School of Finance & Management ( email )

Sonnemannstraße 9-11
Frankfurt am Main, 60314
Germany

Han Xia

University of Texas at Dallas - Naveen Jindal School of Management ( email )

P.O. Box 830688
Richardson, TX 75083-0688
United States

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