Rating Under Asymmetric Information - Inflation Despite Best Intentions

Abstract

We analyze how a firm’s reputation and track record affect its rating and cost of debt. We model a setting in which outsiders such as a rating agency and the firm’s creditors continuously update their assessment of the firm’s true state described by its cash flow. They observe the latter only imperfectly due to asymmetric information. Other things equal, the rating agency optimally rates a firm with the same observed cash flow higher, if the historical minimum is sufficiently low. Thus, the rating is not only driven by the most recent information, but history matters. The rating agency refines its unbiased cash flow estimate by ruling out the most overestimated types, leading to an overestimation at default. In response, the firm delays default and lower asset values are available to creditors upon default.

Keywords: Rating, Performance Sensitive Debt, Asymmetric Information, Learning, Markov Perfect Bayesian Equilibrium

JEL Classification: G12, G14, G32