FINANCIAL RATING AGENCIES: ARE THEY CREDIBLE? - INSIGHTS INTO THE REPORTING INCENTIVES OF RATING AGENCIES IN TIMES OF ENHANCED SYSTEMIC RISK

The paper asks if credit rating agencies have incentives to misrepresent their clients’credit quality during an ongoing systemic crisis. Two important elements are essential fora systemic crisis: (1) Investors are not able to distinguish fundamentally healthy debtorsfrom fundamentally unhealthy ones. (2) Investors tend to cumulatively withdraw theirfunds. Therefore, neither fundamentally healthy nor unhealthy debtors can be expected tosurvive a creditor’s exit. We model a signaling game that reflects these two assumptionsand several others. The game focuses on the creditor’s financial pay-offs and theagency’s reputational pay-offs. We show that there are no separating equilibria in whichagencies report observed credit quality truthfully and creditors make their withdrawal decisioncontingent on this report. Depending on the relevant parameters, four different equilibriaemerge. In three of these equilibria, rating assignments are always ignored by thecreditors. Only in one equilibrium, there is limited transmission of decision-useful informationas both players will adopt mixed strategies. Pure strategy equilibria in which ratingassignments reflect decision-useful information can develop for a certain scope of parametersif some of the above mentioned assumptions are relaxed, i.e. (1) if fundamentallyhealthy firms can survive cumulative creditor’s withdrawal with positive probability, or (2) iftwo rating agencies successively evaluate the debtor. The paper’s findings add to theunderstanding of self-fulfilling prophecy phenomena in financial markets.