Ratings Quality over the Business Cycle
The reduced accuracy of credit ratings on structured finance products in the boom just preceding the financial crisis has prompted investigation into the business of Credit Rating Agencies (CRAs). While CRAs have long held that reputational concerns discipline their behavior, the value of reputation depends on economic fundamentals that vary over the business cycle. We analyze a dynamic model of ratings where reputation is endogenous and the market environment may vary over time. We find that ratings accuracy is countercyclical. Specifically, a CRA is more likely to issue less-accurate ratings when income from fees is high, competition in the labor market for analysts is tough, and default probabilities for the securities rated are low. Persistence in economic conditions can diminish our results, while mean reversion exacerbates them. The presence of naive investors reduces overall accuracy, but ratings accuracy remains countercyclical. Finally, we demonstrate that competition among CRAs yields similar qualitative results.
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|Authors:||Bar-Isaac, Heski ; Shapiro, Joel|
|Type of publication:||Article|
Bar-Isaac, Heski and Shapiro, Joel (2013) Ratings Quality over the Business Cycle. Journal of Financial Economics, 108 (1). pp. 62-78.