Information reliability and welfare: A theory of coarse credit ratings

Anand M. Goel, Anjan V. Thakor

Research output: Contribution to journalArticlepeer-review

45 Scopus citations

Abstract

An enduring puzzle is why credit rating agencies (CRAs) use a few categories to describe credit qualities lying in a continuum, even when ratings coarseness reduces welfare. We model a cheap-talk game in which a CRA assigns positive weights to the divergent goals of issuing firms and investors. The CRA wishes to inflate ratings but prefers an unbiased rating to one whose inflation exceeds a threshold. Ratings coarseness arises in equilibrium to preclude excessive rating inflation. We show that competition among CRAs can increase ratings coarseness. We also examine the welfare implications of regulatory initiatives.

Original languageEnglish
Pages (from-to)541-557
Number of pages17
JournalJournal of Financial Economics
Volume115
Issue number3
DOIs
StatePublished - 1 Mar 2015

Keywords

  • Cheap talk
  • Coarseness
  • Credit quality
  • Credit ratings

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