Precision of Ratings
67 Pages Posted: 13 Mar 2013 Last revised: 11 Aug 2020
Date Written: February 10, 2020
Building on the idea that precision of credit ratings matters for the efficiency of investors' portfolio decisions, the paper analyzes the equilibrium precision of ratings. Our analysis explains why ratings are noisy, exhibit rating inflation and vary across asset classes and over the economic cycle. It also reveals that a laissez-faire CRA provides socially inefficient rating precision and that precision of ratings is further reduced by costly information acquisition. The model is applied to evaluate the post-crisis policy proposals of regulation of CRAs. It explains how CRA response to some but not all regulations can further reduce market efficiency.
Keywords: credit rating agencies, rating precision, information intermediation
JEL Classification: D82, D83, G01, G18, G24, G28, L15
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