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Ratings Shopping and Asset Complexity: A Theory of Ratings Inflation

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  • Vasiliki Skreta
  • Laura Veldkamp

Abstract

Many identify inflated credit ratings as one contributor to the recent financial-market turmoil. We develop an equilibrium model of the market for ratings and use it to examine possible origins of and cures for ratings inflation. In the model, asset issuers can shop for ratings--observe multiple ratings and disclose only the most favorable--before auctioning their assets. When assets are simple, agencies' ratings are similar and the incentive to ratings shop is low. When assets are sufficiently complex, ratings differ enough that an incentive to shop emerges. Thus, an increase in the complexity of recently issued securities could create a systematic bias in disclosed ratings, despite the fact that each ratings agency produces an unbiased estimate of the asset's true quality. Increasing competition among agencies would only worsen this problem. Switching to an investor-initiated ratings system alleviates the bias, but could collapse the market for information.
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Suggested Citation

  • Vasiliki Skreta & Laura Veldkamp, 2008. "Ratings Shopping and Asset Complexity: A Theory of Ratings Inflation," Working Papers 08-28, New York University, Leonard N. Stern School of Business, Department of Economics.
    • Handle: RePEc:ste:nystbu:08-28
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • D02 - Microeconomics - - General - - - Institutions: Design, Formation, Operations, and Impact
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • G01 - Financial Economics - - General - - - Financial Crises
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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