In Mariano (2008) the behaviour of
the CRA is analysed. They analyse the incentives to issue a rating which is not
correct according to the information received by the CRA. In the model the
reputational concerns are not enough to prevent the CRA inflating the report. The
CRA in this setting issues too many false ratings which are biased upwards,
ignoring the true state of the companies. CRAs are more biased when they are
acting in a competitive market. The ratings in this competitive market are more
biased, making sure the rating fee is earned by the agency.
In Boot et. al (2005) the CRAs are
seen as coordination mechanisms. The
CRAs provide a focal point for firms and investors. The CRAs help realizing the
desired equilibrium and so have an economically important role. Boot et. Al
(2005) also analysed if investors could replicate the role of the CRA. The
problem is that the costs are high, when single investors replicate the CRA
role. Collective investors are also not
able to fulfil this role, because of the free-rider problem that would arise.
et al. (2009) analysed a credit rating game where they concluded that
competition between CRAs can reduce efficiency. The reduction in efficiency is
caused by the stimulation of ratings shopping. Bolton et al. (2009) also
concluded that ratings are more likely to be inflated in good economic
environments and when investors are more relying on the ratings. These
aftereffects are created by the conflict of interest arising in these credit
rating games. The first conflict of interest is that the CRA is understating
the risk to earn the rating fee. Secondly, companies are able to purchase the
most favourable ratings. Lastly, the relying nature of the investors causes
The last conflict of
interest is that the investors do not know the true state of the company. CRAs
play an important role in the functioning of the capital markets. Investors in
general do not have the resources and expertise to analyse complex financial products.
The investors rely on the information provided by the CRA.
The second conflict of
interest is that the company can purchase the most favourable ratings. The
company can make a choice whether to buy the rating after having analysed the
report. There are back and forth negotiations when CRAs are making reports. The
company wants to get the highest rating possible from the CRAs, this leads to
competition between the agencies to give the highest rating which results in
earning the fee. The CRAs are criticized for being biased in the rating, for
selling the report in favour of companies.
This conflict of
interest caused many crises such as failures of Enron (2001), Worldcom (2002)
and the recent Financial Crisis (2008). The profits of the CRAs grow extraordinary
with the growth of structured products, for example Moody’s profits tripled
between 2002 and 2006. From 2007 onwards there were large number of downgrades,
which created suspicion that rating standards had been relaxed during the years
before (Brunnermeier, 2009). CRAs may inflate the rating of the investment when
CRAs’ expected reputation cost are lower (Bolton et al., 2012). CRAs have been criticised for responding with
a great time lag. The ratings were not downgraded when the problems in the
sub-prime market became clear, the agencies were slow in adjusting during the
Financial Crisis in 2008.
The CRA has an important role for the functioning of the
financial market, the ratings therefore should be objective and reliable. The
first conflict of interest is that the CRAs’ revenue mainly comes from the
firms positively rated. The principal source of revenue comes from the
companies they are rating. This leads to overstating the creditworthiness of a
company in order to build a good relationship with the entity. On the other
hand, the CRAs must guard their reputation in the market, otherwise the ratings
would be worth less, which leads to a trade-off for the CRA between a
short-term gain from the fee and the long-term reputation of the CRA. By
underrating the risk, the CRA attracts business and so his revenue increases.
2.2 Conflict of interest
Financial managers take
actions concerning capital structure to target minimum credit rating levels
over time. This is done for the benefits related to the higher credit rating. The
capital structure decisions are more based on firm’s credit rating change, than
by change in profitability and leverage (Kisgen, 2009). In Goh and Ederington
(1993) the effect of downgrades on stock returns is analysed. The researchers
concluded that downgrades associated with deteriorating financial prospects
affect stock returns negatively. Interestingly, downgrades associated to change
in firm’s leverage do not.
The rating has an
important effect on the interest rate that borrowers have to pay. Downgrading
leads to a higher interest rate on the loan. Portfolios are sometimes
benchmarked against standard indices that are constructed on credit ratings.
This implies that a downgrade to below the investment-grade threshold triggers
immediate liquidation, which leads to selling the downgraded firm in the
portfolio. This behaviour may increase market volatility and may cause a downward
spiral of asset prices with negative performance of the firm as consequence.
Credit ratings have a significant effect on financial markets, as they affect
bond prices (Hill et al., 2010), and also affect the stock markets. Economic
indicators are priced in the stock price as suggested in Chen et. Al (1986),
including the rating. Brook et al. (2004) analyse that rating downgrades have a
strong negative impact on stock returns, but limited upside potential related
second service of the CRA are the monitoring services, where the companies are
informed about potential downgrades. The CRA points out the aspects that the
company should change, otherwise it is going to get a downgrade. The CRA
signals in advance their plans to change the rating. These signals are
considered to be strong predictors of rating changes relative to other data.
These ratings play an important role in financial markets as investors use them
to determine the credit risk of the related company. The ratings are considered
as a good tool to measure credit quality and positively associated with ratings
accuracy (Frost, 2007). Analysing these credit risks is time consuming, so
investors mainly rely on these ratings. However, the CRAs may vary in precision
rating the firm (Bolton et al, 2011). The CRAs provide imperfect assessments of
default risk. The CRAs also inflate ratings in good economic environment.
Reputational costs discipline the CRAs when inflating the ratings. However, the
value of reputation depends on economic indicators that vary over the business
cycle. Heski and Joel (2012) conclude that rating accuracy is countercyclical,
CRAs are more likely to issue less accurate ratings when revenues are high from
fees. The competition in the labor market for analysts is then tough and the
default probabilities for the investments are low.
is substantial literature on CRAs in microeconomics. The CRA has an important
role in the financial industry. CRAs basically provide two services. They offer
an independent analysis of the capability of companies to meet their debt
obligations. The rating of a CRA only refers to the credit risk, other risks
such as market and liquidity are not covered. CRAs frequently provide different
ratings for the same company. In De Haan (2011) there are given three
explanations for these differences. The first explanation is the difference in
usage of factors and weights in the models for the CRAs. Secondly, rating
agencies may disagree more about speculative-grade rated companies. Lastly,
some CRA rate more favourable in their home region compared to other areas (De
2.1 General information
This section starts with providing
information concerning CRAs, investors and firms. Furthermore, literature related
to conflict of interest in credit rating will be reviewed. Lastly, equilibria
found in literature concerning credit rating games will be analysed.
formalize the situation in a game, and I will focus on analysing theoretical
focal points, i.e. equilibria of this game. This paper is organized as follows;
the second section gives an introduction into the subject and reviews related
literature. The third section describes the game followed by the fourth section
which gives the results of the model. Finally, the fifth section gives the
another important conflict of interest is the trusting of the investors
concerning the ratings. Some of the investors do not understand the conflict of
interest of the CRAs. They follow the rating of the CRA, which is not always
advisable. CRA credit models may vary in precision, which leads to imperfect
assessments of default risk (Bolton et al., 2012). Most of the investors were not able to see
through imperfect ratings, as in the Financial Crisis (Taylor, 2009).
other conflict of interest is the issuers’ ability to purchase the highest
rating. The firm has the possibility to buy the report or try another CRA,
which causes back and forth negotiations (Bongaerts et al., 2012).
The CRAs acknowledges that
conflict of interest arises from the fact that firms have to pay for the
ratings. According to the CRAs, they are well capable to manage the conflicts. Before
the Financial Crisis, the CRA profits rapidly increased, for instance Moody’s profits
almost tripled between 2002 and 2006 (Bolton et al., 2012). After the Financial
Crisis, there were large number of downgrades by the CRAs. The CRAs relaxed the
rating standards before the crisis, which was tightened after the crisis by the
large number of downgrades. The downgrades were caused by the higher rating standards implemented
by the CRAs.
main problem that arises concerning the CRAs, is that their revenue comes from
the firms they are rating. The ratings are inflated to stimulate the rated
firms buying the ratings, and so the CRA collects fee. CRAs focus on rating
debt products and credit derivatives, which generate the biggest share of their
revenues. Almost 90 percent of credit rating agencies’ revenues come from
company fees (Benmelech
& Dlugosz, 2010). The fees that CRAs collect vary depending on the
complexity and size of the issue.
Credit rating agencies (CRAs)
analyse the creditworthiness of companies and their financial obligations.
After the financial crisis, the CRAs have been criticized concerning their
inflated ratings. The accounting and auditing scandals led to many questions
concerning the ratings and their competence. One of the most famous example is
the case of Enron (2001), which was caused by the conflict of interest in the