Repeated Interaction and Rating Inflation: A Model of Double Reputation
American Economic Journal: Microeconomics, February 2015, 7(1): 250-80.
44 Pages Posted: 14 Dec 2012 Last revised: 22 Feb 2015
Date Written: February 11, 2014
Credit-rating agencies have an incentive to maintain a public reputation for credibility among investors but also have an incentive to develop a second, private reputation for leniency among issuers. We show that in markets with few issuers, such as markets for structured assets, these incentives may lead rating agencies to inflate ratings as a strategic tool to form a “double reputation.” The model extends the existing literature on “cheap-talk” reputation to the case of two audiences. Our results can explain why rating inflation occurred specifically in markets for MBSs and CDOs during the recent financial crisis. Policy implications are discussed.
Keywords: credit-rating agencies, reputation, double reputation, two audiences
JEL Classification: G24, D82, L15, C73
Suggested Citation: Suggested Citation