The Dual Role of Ratings

Abstract

This paper studies the design of revenue-maximizing rating schemes. I show that optimal schemes leverage adverse selection to alleviate moral hazard over time. They admit a coarse and opaque structure, transferring positive rents from a competent firm to an inept firm. I illustrate their implications for market beliefs and firm behaviors, a tension between rating transparency and economic efficiency, and a relationship between moral hazard and complexity of the rating structure. The results reconcile a folk wisdom that ratings alleviate information asymmetries with concerns that ratings add little information to markets.

Keywords: ratings, repeated games, reputation, certification, information intermediation.

JEL Classification: C72, C73, D82, D83, M52, G24