Credit Rating Inflation and Firms' Investments

Abstract

We analyze credit ratings' effects on firms' investments in a rational debt-financing game that features a feedback loop. The credit rating agency (CRA) inflates the rating, providing a biased but informative signal to creditors. Creditors' response to the rating affects the firm's investment decision and credit quality, which is reflected in the rating. The CRA might reduce ex-ante economic efficiency, which results solely from the feedback effect of the rating: The CRA assigns more firms high ratings and allows them to gamble for resurrection. We derive empirical predictions on the determinants of rating standards and inflation and discuss policy implications.

Keywords: Credit rating agency, rating inflation, real effect, feedback effect

JEL Classification: D82, D83, G24, G32