The Dual Role of Ratings

Abstract

A conventional wisdom is that ratings exist to solve adverse selection and moral hazard problems. Raters often collect payments from their ratees. It is unclear whether rating schemes tailored to maximize ratees' payments solve adverse selection and moral hazard problems. I prove that ratings which fully extract the ratee's net surplus entirely solve moral hazard by leveraging the presence of adverse selection over time. I find a tension between rating transparency and economic efficiency --- ratings that maximize the ratee's and the market's surplus are opaque. I illustrate the relationship between rating coarseness and moral hazard, as well as the implications of fully-extracting ratings for market beliefs and behaviors. I reconcile the conventional wisdom with critiques that ratings add little information to the markets.

Keywords: ratings, repeated games, reputation, information intermediation

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