Why Are Credit Ratings Coarse?

41 Pages Posted: 26 Sep 2013

See all articles by Anand M. Goel

Anand M. Goel

Stevens Institute of Technology

Anjan V. Thakor

Washington University, Saint Louis - John M. Olin School of Business; European Corporate Governance Institute (ECGI)

Date Written: September 21, 2013

Abstract

An enduring puzzle is why credit ratings are coarse indicators of issuer credit quality, with a relatively small number of ratings categories being used to describe credit qualities that lie in a continuum. We develop a theoretical model to explain why ratings are coarse even though coarseness reduces welfare. We model the ratings-determination process as a cheap-talk game in which there is a divergence between the goals of issuing firms and those of investors, and the rating agency's objective gives positive weight to both goals. We show that the rating agency is willing to inflate ratings, but wishes to keep the rating inflation below a threshold bias. Consequently, it prefers an unbiased rating to a rating inflated by an amount exceeding the threshold bias. Coarse ratings arise as an equilibrium phenomenon due to the effects of these forces. The coarseness of ratings means that rating inflation, if it were to exist, would have to exceed the threshold bias, so ratings exhibit no bias/inflation in equilibrium, and legal liability to eliminate bias is unnecessary. Moreover, competition among rating agencies does not necessarily reduce ratings coarseness. We also examine welfare implications of regulatory initiatives involving ratings.

Keywords: credit ratings, coarseness, cheap talk, credit quality

JEL Classification: D82, D83, G24, G28, G31, G32

Suggested Citation

Goel, Anand Mohan and Thakor, Anjan V., Why Are Credit Ratings Coarse? (September 21, 2013). Available at SSRN: https://ssrn.com/abstract=2330585 or http://dx.doi.org/10.2139/ssrn.2330585

Anand Mohan Goel (Contact Author)

Stevens Institute of Technology ( email )

Hoboken, NJ 07030
United States

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

Anjan V. Thakor

Washington University, Saint Louis - John M. Olin School of Business ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

European Corporate Governance Institute (ECGI) ( email )

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

Register to save articles to
your library

Register

Paper statistics

Downloads
119
Abstract Views
871
rank
236,463
PlumX Metrics