DP8156 Ratings Quality over the Business Cycle

Author(s): Heski Bar-Isaac, Joel Shapiro
Publication Date: December 2010
Keyword(s): Credit rating agencies, Ratings Accuracy, Reputation
JEL(s): G24, L14
Programme Areas: Financial Economics, Industrial Organization
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=8156

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 their behavior is disciplined by reputational concerns, the value of reputation depends on economic fundamentals that vary over the business cycle. These include income from fees, default probabilities for the securities rated, competition in the labor market for analysts, and expectations about the future. We analyze a dynamic model of ratings where reputation is endogenous and the market environment may vary over time. We find that a CRA is more likely to issue less accurate ratings in boom times than during recessionary periods. Persistence in economic conditions can diminish our results, while mean reversion exacerbates them. Finally, we demonstrate that competition among CRAs yields similar qualitative results.