Ratingsshoppingandassetcomplexity:Atheoryof ratingsinflation

Manyidentifyinflatedcreditratingsasonecontributortotherecentfinancial-market turmoil.Wedevelopanequilibriummodelofthemarketforratingsanduseitto examinepossibleoriginsofandcuresforratingsinflation.Inthemodel,assetissuers can shopforratings—observe multipleratingsanddiscloseonlythemostfavorable— before auctioningtheirassets.Whenassetsaresimple,agencies’ratingsaresimilarand theincentivetoratingsshopislow.Whenassetsaresufficientlycomplex,ratingsdiffer enoughthatanincentivetoshopemerges.Thus,anincreaseinthecomplexityof recently issuedsecuritiescouldcreateasystematicbiasindisclosedratings,despitethe fact thateachratingsagencyproducesanunbiasedestimateoftheasset’struequality. Increasing competitionamongagencieswouldonlyworsenthisproblem.Switchingto an investor-initiatedratingssystemalleviatesthebias,butcouldcollapsethemarketfor information.