Information reliability and welfare: A theory of coarse credit ratings

TitleInformation reliability and welfare: A theory of coarse credit ratings
Publication TypeJournal Article
Year of Publication2015
AuthorsGoel AM, Thakor AV
JournalJournal of Financial Economics
Date PublishedMar
ISBN Number0304-405X
Accession NumberWOS:000351250800007

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. (C) 2015 Published by Elsevier B.V.