Who Prices Credit Rating Inflation?

Abstract

Credit rating agencies (CRAs) are less likely and slower to downgrade firms with performance-sensitive debt (PSD) if these downgrades increase borrowing costs. This effect is stronger when CRAs rate their most profitable clients and is not driven by selection into PSD contracts or by borrowers hiding information. Moreover, originating banks are aware of and price the CRAs' conflicts of interest, and sell loans with more embedded conflicts more frequently. In contrast, secondary market participants do not price conflicts of interest to the same extent. The recent settlements between the major CRAs and the U.S. government do not prevent rating inflation.

Keywords: Credit ratings, performance-sensitive debt, rating catering

JEL Classification: G14, G24, G28