The Dual Role of Ratings

54 Pages Posted: 2 May 2019 Last revised: 21 Jun 2019

Date Written: April 1, 2019

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

Suggested Citation

Vong, Allen, The Dual Role of Ratings (April 1, 2019). Available at SSRN: https://ssrn.com/abstract=3363690 or http://dx.doi.org/10.2139/ssrn.3363690

Allen Vong (Contact Author)

Yale University ( email )

New Haven, CT 06520
United States

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