Thursday, April 2, 2009

Credit rating inflation and naive investors

Imagine that employers determine the quality of job applicants by looking at their GPA (grade point average). Then obviously, colleges would want to give good grades to their students to give them better chances on the job market. To attract tuition paying students, colleges promise good grades. This scheme will work as look as there are some naive employers that do not see that they are getting fooled by grade inflation.

Patrick Bolton, Xavier Freixas and Joel Shapiro argue that this is exactly what happened with the credit rating agencies, which are financed by the very institutions they are rating. And the latter shop around for the better ratings. As long as there are naive investors willing to believe whatever the credit rating agencies say, the rating inflation will continue. The authors show with a model that the optimal policy response is to force disclosure of all ratings. One would not have needed a formal model to realize that. More interesting is that they show that a monopoly can in fact lead to better outcomes, for once, because it does not lead to rating inflation. Monopolies bring other inefficiencies, however, and we are already advocating the public provision of ratings...

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