The spectacular failure of top-rated structured …nance products has brought renewed attention to the con‡icts of interest of Credit Rating Agencies (CRAs). We model both the CRA con‡ict of understating credit risk to attract more business, and the issuer con‡ict of purchasing only the most favorable ratings (issuer shopping), and examine the eectiveness of a number of proposed regulatory solutions of CRAs. We …nd that CRAs are more prone to in‡ate ratings when there is a larger fraction of naive investors in the market who take ratings at face value, or when CRA expected reputation costs are lower. To the extent that in booms the fraction of naive investors is higher, and the reputation risk for CRAs of getting caught understating credit risk is lower, our model predicts that CRAs are more likely to understate credit risk in booms than in recessions. We also show that, due to issuer shopping, competition among CRAs in a duopoly is less e¢ cient (conditional on the same equilibrium CRA rating policy) than having a monopoly CRA, in terms of both total ex-ante surplus and investor surplus. Allowing tranching decreases total surplus further. We argue that regulatory intervention requiring upfront payments for rating services (before CRAs propose a rating to the issuer) combined with mandatory disclosure of any rating produced by CRAs can substantially mitigate the con‡icts of interest of both CRAs and issuers.

/pdf/the-credit-ratings-game-4h9p2ost0g.pdf

The Credit Ratings Game

This essay reviews the theoretical and empirical literature on quality disclosure and certification. After comparing quality disclosure with other quality assurance mechanisms and describing a brief history of quality disclosure, we address two sets of theoretical issues. First, why don't sellers voluntarily disclose through a process of "unraveling" and, given the lack of unraveling, is it desirable to mandate seller disclosure? Second, when we rely on certifiers to act as the intermediary of quality disclosure, do certifiers necessarily report unbiased and accurate information? We further review empirical evidence on these issues, with a particular focus on healthcare, education, and finance. The empirical review covers quality measurement, the effect of third-party disclosure on consumer choice and seller behavior, as well as the economics of certifiers. (JEL D18, K32, L15, M31)

https://www.nber.org/system/files/working_papers/w15644/w15644.pdf

Quality Disclosure and Certification: Theory and Practice

The collapse of so many AAA-rated structured finance products in 2007-2008 has brought renewed attention to the causes of ratings failures and the conflicts of interest in the Credit Ratings Industry. We provide a model of competition among Credit Ratings Agencies (CRAs) in which there are three possible sources of conflicts: 1) the CRA conflict of interest of understating credit risk to attract more business; 2) the ability of issuers to purchase only the most favorable ratings; and 3) the trusting nature of some investor clienteles who may take ratings at face value. We show that when combined, these give rise to three fundamental equilibrium distortions. First, competition among CRAs can reduce market efficiency, as competition facilitates ratings shopping by issuers. Second, CRAs are more prone to inflate ratings in boom times, when there are more trusting investors, and when the risks of failure which could damage CRA reputation are lower. Third, the industry practice of tranching of structured products distorts market efficiency as its role is to deceive trusting investors. We argue that regulatory intervention requiring: i) upfront payments for rating services (before CRAs propose a rating to the issuer), ii) mandatory disclosure of any rating produced by CRAs, and iii) oversight of ratings methodology can substantially mitigate ratings inflation and promote efficiency.

This paper will explore how the financial regulatory structure propelled three credit rating agencies -- Moody's, Standard & Poor's (S&P), and Fitch -- to the center of the U.S. bond markets -- and thereby virtually guaranteed that when these rating agencies did make mistakes, these mistakes would have serious consequences for the financial sector. We begin by looking at some relevant history of the industry, including the series of events that led financial regulators to outsource their judgments to the credit rating agencies (by requiring financial institutions to use the specific bond creditworthiness information that was provided by the major rating agencies) and when the credit rating agencies shifted their business model from "investor pays" to "issuer pays." We then look at how the credit rating industry evolved and how its interaction with regulatory authorities served as a barrier to entry. We then show how these ingredients combined to contribute to the subprime mortgage debacle and associated financial crisis. Finally, we consider two possible routes for public policy with respect to the credit rating industry: One route would tighten the regulation of the rating agencies, while the other route would reduce the required centrality of the rating agencies and thereby open up the bond information process in a way that has not been possible since the 1930s.

/pdf/markets-the-credit-rating-agencies-2we1ac10em.pdf

Markets: The Credit Rating Agencies

http://apps.olin.wustl.edu/faculty/milbourn/BeckerMilbournApril2010.pdf

How did increased competition affect credit ratings

Rating the raters: Are reputation concerns powerful enough to discipline rating agencies?☆☆☆

https://www.tse-fr.eu/sites/default/files/medias/doc/by/mathis/frisrgp.pdf

Full Revelation of Information in Sender-Receiver Games of Persuasion

In committee deliberation, requiring a unanimous vote intuitively provides the strongest incentives for actors to share fully their opinions and private information. It is also believed that full revelation of (decision-relevant) information occurs when personal biases are made clear before deliberation. However, recent literature suggests that both intuitions are flawed. Austen-Smith and Feddersen propose a model in which the unanimity rule performs worse than other rules in promoting fully revealing deliberation, and uncertainty about individuals' preferences promotes full sharing of information. We extend this work by incorporating the possibility that individuals may provide verifiable evidence for their private information. Under this circumstance, we demonstrate that Austen-Smith and Feddersen's results are reversed. First, a unanimous voting rule performs better than any other, as unanimity is the only rule that always promotes fully revealing deliberation. Second, under fairly general conditions, uncertainty about individuals' preferences prevents full sharing of information.

Deliberation with Evidence

Argumentation in Sender-Receiver Games

We study a situation where a decision maker relies on the report of a self-interested and informed expert prior to decide whether to undertake a certain project. An important feature in this interaction is that, depending on the collected information, the two agents have potentially conflicting preferences. Information contained in the report is partially verifiable in the sense that the expert can suppress favorable information sustaining the project but he cannot exaggerate it. Our results show that this setting favors the agent which is the less eager to undertake the project in that he always succeeds to induce his most preferred action.

/pdf/consulting-an-expert-with-potentially-conflicting-51cdoa3f9j.pdf

Consulting an Expert with Potentially Conflicting Preferences

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