Credit Rating Inflation and Firms' Investments
Corresponding Author
ITAY GOLDSTEIN
Correspondence: Itay Goldstein, Wharton School of Business, University of Pennsylvania. itayg@wharton.upenn.edu.
Search for more papers by this authorCHONG HUANG
Itay Goldstein is at Wharton School of Business, University of Pennsylvania. Chong Huang is at Paul Merage School of Business, University of California, Irvine. We would like to thank Wei Xiong (Editor), an anonymous Associate Editor, and two anonymous referees for insightful comments and suggestions. We also thank Philip Bond; Michael Brennan; Barney Hartman-Glaser; Jie He; David Hirshleifer; Yunzhi Hu; Anastasia Kartasheva; Christian Laux; Michael Lee; Xuewen Liu; Stefan Nagel; Christine Parlour; Uday Rajan; Laura Veldkamp; Han Xia; and seminar and conference participants at UC Irvine, Peking University, Renmin University, University of Arizona, Johns Hopkins University, University of Michigan, SEC, UC Berkeley, EIEF, Tsinghua PBC, Nanyang Technological University, Chinese University of Hong Kong, VGSF, USC, Columbia, Duke, UNC Chapel Hill, Dartmouth, UT Dallas, 2015 LA Finance Day conference, 2015 ESSFM, 2015 Econometric Society World Congress, the third Southern California Finance Conference, the conference of Economics of Credit Rating Agencies, Credit Ratings and Information Intermediaries, 2016 AEA, 2016 EWFS, 2016 OxFIT, 2017 SFS Cavalcade, 2017 FIRS, 2017 Barcelona GSE Summer Forum, the 17th Meeting of the Finance Theory Group, and 2018 UT Austin Theoretical Accounting Conference for comments and suggestions. The authors have read The Journal of Finance disclosure policy and have no conflicts of interest to disclose.
Search for more papers by this authorCorresponding Author
ITAY GOLDSTEIN
Correspondence: Itay Goldstein, Wharton School of Business, University of Pennsylvania. itayg@wharton.upenn.edu.
Search for more papers by this authorCHONG HUANG
Itay Goldstein is at Wharton School of Business, University of Pennsylvania. Chong Huang is at Paul Merage School of Business, University of California, Irvine. We would like to thank Wei Xiong (Editor), an anonymous Associate Editor, and two anonymous referees for insightful comments and suggestions. We also thank Philip Bond; Michael Brennan; Barney Hartman-Glaser; Jie He; David Hirshleifer; Yunzhi Hu; Anastasia Kartasheva; Christian Laux; Michael Lee; Xuewen Liu; Stefan Nagel; Christine Parlour; Uday Rajan; Laura Veldkamp; Han Xia; and seminar and conference participants at UC Irvine, Peking University, Renmin University, University of Arizona, Johns Hopkins University, University of Michigan, SEC, UC Berkeley, EIEF, Tsinghua PBC, Nanyang Technological University, Chinese University of Hong Kong, VGSF, USC, Columbia, Duke, UNC Chapel Hill, Dartmouth, UT Dallas, 2015 LA Finance Day conference, 2015 ESSFM, 2015 Econometric Society World Congress, the third Southern California Finance Conference, the conference of Economics of Credit Rating Agencies, Credit Ratings and Information Intermediaries, 2016 AEA, 2016 EWFS, 2016 OxFIT, 2017 SFS Cavalcade, 2017 FIRS, 2017 Barcelona GSE Summer Forum, the 17th Meeting of the Finance Theory Group, and 2018 UT Austin Theoretical Accounting Conference for comments and suggestions. The authors have read The Journal of Finance disclosure policy and have no conflicts of interest to disclose.
Search for more papers by this authorABSTRACT
We analyze credit rating effects on firm investments in a rational bond financing game that features a feedback loop. The credit rating agency (CRA) inflates the rating, providing a biased but informative signal to creditors. Creditors' response to the rating affects the firm's investment decision and thus its credit quality, which is reflected in the rating. The CRA might reduce ex ante economic efficiency, which results solely from its strategic effect: the CRA assigns more firms high ratings and allows them to gamble for resurrection. We derive empirical predictions on the determinants of rating standards and inflation and discuss policy implications.
Supporting Information
| Filename | Description |
|---|---|
| jofi12961-sup-0001-OnlineAppendix.pdf276.9 KB | Appendix S1: Internet Appendix. |
| jofi12961-sup-0002-ReplicationCode.zip1.9 KB | Replication code. |
Please note: The publisher is not responsible for the content or functionality of any supporting information supplied by the authors. Any queries (other than missing content) should be directed to the corresponding author for the article.
REFERENCES
- Almeida, Heitor, Igor Cunha, Miguel A. Ferreira, and Felipe Restrepo, 2017, The real effects of credit ratings: The sovereign ceiling channel, Journal of Finance 72, 249–290.
- Alp, Aysun, 2013, Structural shifts in credit rating standards, Journal of Finance 68, 2435–2470.
- Angeletos, George-Marios, Christian Hellwig, and Alessandro Pavan, 2006, Signaling in a global game: Coordination and policy traps, Journal of Political Economy 114, 452–484.
- Angeletos, George-Marios, Christian Hellwig, and Alessandro Pavan, 2007, Dynamic global games of regime change: Learning, multiplicity, and the timing of attacks, Econometrica 75, 711–756.
- Angeletos, George-Marios, and Alessandro Pavan, 2013, Selection-free predictions in global games with endogenous information and multiple equilibria, Theoretical Economics 8, 883–938.
- Baghai, Ramin P., Henri Servaes, and Ane Tamayo, 2014, Have rating agencies become more conservative? Implications for capital structure and debt pricing, Journal of Finance 69, 1961–2005.
- Bannier, Christina E., Christian W. Hirsch, and Markus Wiemann, 2012, Do credit ratings affect firm investments? The monitoring role of rating agencies, Working paper, Johannes Gutenberg-University Mainz.
- Bolton, Patrick, Xavier Freixas, and Joel Shapiro, 2012, The credit ratings game, Journal of Finance 67, 85–111.
- Boot, Arnoud W. A., Todd T. Milbourn, and Anjolein Schmeits, 2006, Credit ratings as coordination mechanisms, Review of Financial Studies 19, 81–118.
- Bouvard, Matthieu, Pierre Chaigneau, and Adolfo De Motta, 2015, Transparency in the financial system: Rollover risk and crises, Journal of Finance 70, 1805–1837.
- Carlsson, Hans, and Eric van Damme, 1993, Global games and equilibrium selection, Econometrica 61, 989–1018.
- Cornaggia, Jess, and Kimberly J. Cornaggia, 2013, Estimating the costs of issuer-paid credit ratings, Review of Financial Studies 26, 2229–2269.
- Crawford, Vincent, and Joel Sobel, 1982, Strategic information transmission, Econometrica 50, 1431–1451.
- Daley, Brendan, Brett Green, and Victoria Vanasco, 2020, Securitization, ratings, and credit supply, Journal of Finance 75, 1037–1082.
- Donaldson, Jason, and Giorgia Piacentino, 2018, Contracting to compete for flows, Journal of Economic Theory 173, 289–319.
- Edmond, Chris, 2013, Information manipulation, coordination and regime change, Review of Economic Studies 80, 1422–1458.
- Fong, Kingsley Y. L., Harrison G. Hong, Marcin T. Kacperczyk, and Jeffrey D. Kubik, 2014, Do security analysts discipline credit rating agencies? Working paper, University of New South Wales.
- Frenkel, Sivan, 2015, Repeated interaction and rating inflation: A model of double reputation, American Economic Journal: Microeconomics 7, 250–280.
- Goel, Anand M., and Anjan V. Thakor, 2015, Information reliability and welfare: A theory of coarse credit ratings, Journal of Financial Economics 115, 541–557.
- Goldstein, Itay, and Chong Huang, 2016, Bayesian persuasion in coordination games, American Economic Review Papers and Proceedings 106, 592–596.
- Goldstein, Itay, and Yaron Leitner, 2018, Stress tests and information disclosure, Journal of Economic Theory 77, 34–69.
- He, Zhiguo, and Wei Xiong, 2012, Dynamic debt runs, Review of Financial Studies 25, 1799–1843.
- Holden, Steiner, Gisle James Natvik, and Adrien Vigier, 2018, Credit rating and debt crises, International Economic Review 59, 973–987.
- Huang, Chong, 2017, Defending against speculative attacks: The policy maker's reputation, Journal of Economic Theory 107, 1–34.
- Inostroza, Nicolas, and Alessandro Pavan, 2018, Persuasion in global games with application to stress testing, Working paper, Northwestern University.
- Jiang, John (Xuefeng), Mary Harris Stanford, and Yuan Xie, 2012, Does it matter who pays for bond ratings? Historical evidence, Journal of Financial Economics 105, 607–621.
- Kamenica, Emir, and Matthew Gentzkow, 2011, Bayesian persuasion, American Economic Review 101, 2590–2615.
- Manso, Gustavo, 2013, Feedback effects of credit ratings, Journal of Financial Economics 109, 535–548.
- Mathis, Jérôme, James McAndrews, and Jean-Charles Rochet, 2009, Rating the raters: Are reputation concerns powerful enough to discipline rating agencies? Journal of Monetary Economics 56, 657–674.
- Morris, Stephen, and Hyun Song Shin, 2002, Social value of public information, American Economic Review 92, 1521–1534.
- Morris, Stephen, and Hyun Song Shin, 2003, Global games: Theory and applications, in Advances in Economics and Econometrics: Theory and Applications, vol. 1. pp. 57–114 (Cambridge University Press, Cambridge).
10.1017/CBO9780511610240.004 Google Scholar
- Morris, Stephen, and Hyun Song Shin, 2004, Coordination risk and the price of debt, European Economic Review 48, 133–153.
- Opp, Christian, Marcus Opp, and Milton Harris, 2013, Rating agencies in the face of regulation, Journal of Financial Economics 108, 46–61.
- Parlour, Christine, and Uday Rajan, 2020, Contracting on credit ratings: Adding value to public information, Review of Financial Studies 33, 1412–1444.
- Skreta, Vasiliki, and Laura Veldkamp, 2009, Ratings shopping and asset complexity: A theory of ratings inflation, Journal of Monetary Economics 56, 678–695.
- Strobl, Günter, and Han Xia, 2012, The issuer-pays rating model and ratings inflation: Evidence from corporate credit ratings, Working paper, University of Texas at Dallas.
- Sufi, Amir, 2009, The real effects of debt certification: Evidence from the introduction of bank loan ratings, Review of Financial Studies 22, 1659–1691.
- White, Lawrence, 2013, Credit rating agencies: An overview, Annual Review of Financial Economics 5, 93–122.
