Imperfect Information Transmission from Banks to Investors: Macroeconomic Implications

Abstract

We study the interaction of information production in loan-backed asset markets and credit allocation in a general equilibrium framework. Originating banks can screen their borrowers, but can inform investors of their asset type only through an error-prone rating technology. The premium paid on highly rated assets emerges as the main determinant of screening effort. Because the rating technology is imperfect, this premium is insufficient to induce the efficient level of screening. However, the fact that banks know their asset quality and produce ratings accordingly helps keep the premium high. Mandatory rating, certified review, and mandatory ratings disclosure policies interfere with this decision margin, thereby reducing informativeness of high ratings, lowering the premium paid on them, and exacerbating the credit misallocation problem. We perform optimal policy analysis.

Keywords: credit misallocation, information asymmetry, information production, screening effort, rising asset complexity, mandatory rating, mandatory ratings disclosure

JEL Classification: G01, G24, G28