Credit Rating Categories

Abstract

In this paper I develop a model that explains why credit rating agencies classify bonds into coarse categories. The optimal number of categories and their cutoffs are outcomes of profit maximization by a rating agency. The trade-off between the number of issuers that are willing to pay for a rating and how much they are willing to pay determines these optima. The model predicts that rating standards will be tighter during non-crisis periods. It also predicts that new issuer-pay rating agencies will not use finer categories because finer categories provide less incentive for bond issuers to solicit (pay for) a rating. Consistent with the model's prediction, empirical tests show that rating standards are tighter during non-crisis periods.

Keywords: Credit rating, Categorization, Solicited and unsolicited ratings, Category cutoffs, Rating standards

JEL Classification: G20