The Impact of Credit Ratings on Capital Markets

Abstract

We develop a model of investment financing which is characterized by the interplay of information asymmetry regarding the project's productivity and lack of commitment about the allocation of productive resources. This environment gives rise to a feedback effect between managerial actions and the creditors' beliefs about them. We find that informative credit ratings alleviate the information asymmetry between the manager of a rm and its creditors, but strengthen (on average) the incentive to withdraw productive resources from the project, and subsequently default. We characterize the conditions under which informative credit ratings worsen financing opportunities and lead to a higher expected probability of default and cost of capital. Finally, we study the implications for the regulation of credit rating agencies.

Keywords: Information Disclosure, Credit Rating Agencies, Feedback Effect, Financial Regulation

JEL Classification: D82, D83, G24