Credit Rating Inflation and Firms' Investments

58 Pages Posted: 7 Dec 2017 Last revised: 4 Sep 2019

See all articles by Itay Goldstein

Itay Goldstein

University of Pennsylvania - The Wharton School - Finance Department

Chong Huang

University of California, Irvine - Paul Merage School of Business

Date Written: September 3, 2019

Abstract

We analyze credit ratings' effects on firms' investments in a rational debt-financing game that features a feedback loop. The credit rating agency (CRA) inflates the rating, providing a biased but informative signal to creditors. Creditors' response to the rating affects the firm's investment decision and credit quality, which is reflected in the rating. The CRA might reduce ex-ante economic efficiency, which results solely from the feedback effect of the rating: The CRA assigns more firms high ratings and allows them to gamble for resurrection. We derive empirical predictions on the determinants of rating standards and inflation and discuss policy implications.

Keywords: Credit rating agency, rating inflation, real effect, feedback effect

JEL Classification: D82, D83, G24, G32

Suggested Citation

Goldstein, Itay and Huang, Chong, Credit Rating Inflation and Firms' Investments (September 3, 2019). Available at SSRN: https://ssrn.com/abstract=3082428 or http://dx.doi.org/10.2139/ssrn.3082428

Itay Goldstein

University of Pennsylvania - The Wharton School - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-746-0499 (Phone)

Chong Huang (Contact Author)

University of California, Irvine - Paul Merage School of Business ( email )

Irvine, CA 92697-3125
United States

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