Credit Rating Inflation and Firms' Investments

• Author: ITAY GOLDSTEIN,CHONG HUANG
• DOI: http://doi.org/10.1111/jofi.12961
• Published date: 01 December 2020
• Date: 01 December 2020

THE JOURNAL OF FINANCE •VOL. LXXV, NO. 6 •DECEMBER 2020

Credit Rating Inflation and Firms’ Investments

ITAY GOLDSTEIN and CHONG HUANG∗

ABSTRACT

We analyze credit rating effects on firm investments in a rational bond financing

game that features a feedback loop. The credit rating agency (CRA) inflates the rat-

ing, providing a biased but informative signal to creditors. Creditors’ response to the

rating affects the firm’s investment decision and thus its credit quality, which is re-

flected in the rating. The CRA might reduce ex ante economic efficiency, which results

solely from its strategic effect: 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.

CREDIT RATING AGENCIES (CRAS)HAVE BEEN criticized for playing a central

role in financial failures, such as the collapse of Enron and WorldCom in 2002

and the 2007–2009 financial crisis that led the Financial Crisis Inquiry Re-

port to conclude that “the failures of CRAs were essential cogs in the wheel

of financial destruction.” Critics claim that CRAs assign overgenerous ratings,

and several empirical studies find support for this view.1These studies argue

that the documented credit rating inflation may be due to conflicts of interest

arising from the use of an “issuer-pays” business model, whereby CRAs are

∗Itay Goldstein is at Wharton School of Business, University of Pennsylvania. Chong Huang is

at Paul Merage School of Business, University of California, Irvine. We would like to thank Wei

Xiong (Editor), an anonymous Associate Editor, and two anonymous referees for insightful com-

ments and suggestions. Wealso thank Philip Bond; Michael Brennan; Barney Hartman-Glaser; Jie

He; David Hirshleifer; Yunzhi Hu; Anastasia Kartasheva; Christian Laux; Michael Lee; Xuewen

Liu; Stefan Nagel; Christine Parlour; Uday Rajan; Laura Veldkamp; Han Xia; and seminar and

conference participants at UC Irvine, Peking University, Renmin University, University of Ari-

zona, Johns Hopkins University,University of Michigan, SEC, UC Berkeley, EIEF, Tsinghua PBC,

Nanyang Technological University, Chinese University of Hong Kong, VGSF, USC, Columbia,

Duke, UNC Chapel Hill, Dartmouth, UT Dallas, 2015 LA Finance Day conference, 2015 ESSFM,

2015 Econometric Society World Congress, the third Southern California Finance Conference, the

conference of Economics of Credit Rating Agencies, Credit Ratings and Information Intermedi-

aries, 2016 AEA, 2016 EWFS, 2016 OxFIT, 2017 SFS Cavalcade, 2017 FIRS, 2017 Barcelona GSE

Summer Forum, the 17th Meeting of the Finance Theory Group, and 2018 UT Austin Theoreti-

cal Accounting Conference for comments and suggestions. The authors have read The Journal of

Finance disclosure policy and have no conflicts of interest to disclose.

Correspondence: Itay Goldstein, Wharton School of Business, University of Pennsylvania.

itayg@wharton.upenn.edu.

1See, for example, Jiang, Stanford, and Xie (2012), Strobl and Xia (2012), and Cornaggia and

Cornaggia (2013).

DOI: 10.1111/jofi.12961

© 2020 the American Finance Association

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2930 The Journal of Finance®

paid by the issuers they are assessing. The concern is that by misleading cred-

itors, inflated credit ratings help risky investments get funded and as a result

have negative real effects.

Thinking about these arguments through the lens of models with rational

creditors, it is not clear why inflated credit ratings would have negative real

effects. Credit ratings must provide creditors with some valuable information,

as otherwise the ratings would be ignored and CRAs would have no effect. But

if CRAs provide informative (though potentially biased) signals, they should

be able to increase, rather than decrease, economic efficiency, even if they do

not lead to the first-best outcome. The question then is whether CRAs with a

motive to inflate ratings can have negative effects on economic efficiency in a

world with rational creditors.

In this paper, we develop a model to analyze this question. We show that in

equilibrium, a CRA with an incentive to inflate ratings pools firms with eco-

nomic fundamentals above a threshold and assigns them a rating indicative of

high credit quality,despite the fact that some of them will choose risky projects

and thus have low credit quality. Accordingly, the high credit rating is inflated

but informative. High-rating firms enjoy lower financial costs. However, given

lower financial costs, some firms that would have defaulted efficiently without

the CRA will gamble for resurrection, leading to lower economic efficiency.2

Our model is parsimonious but rich enough to capture the essential factors

of the interactions between a CRA, creditors, and an issuing firm. First, we

consider a CRA that, by assigning a higher rating, earns higher revenue but

incurs a higher cost if the firm fails. In particular, if the CRA assigns a high

rating to a firm that has extremely bad economic fundamentals and that will

default immediately despite the high rating, the CRA will incur an extremely

high cost. This high cost in the event of firm failure prevents the CRA from

assigning high ratings to firms with extremely bad economic fundamentals

and thereby imposes a restriction on the CRA’s rating strategy. We refer to

this restriction as the partial verifiability constraint. Given this constraint,

the CRA’s rating, while perhaps biased, contains valuable information. Sec-

ond, the credit rating is used by rational creditors who have dispersed beliefs

about a firm’s economic fundamentals and decide whether to buy bonds issued

by the firm based on their private information and the CRA’s credit rating.

Third, the creditors’ decisions together affect the firm’s cost of capital and in

turn affect the firm’s investment decision, which determines the firm’s credit

quality.Fourth, when setting the rating, the CRA accounts for the effects of the

rating on the decisions of creditors and the firm and the effects of these deci-

sions on the firm’s credit quality. As a result, there is a feedback loop whereby

the rating affects creditors’ behavior, which affects the behavior of the issuer

and its credit quality, which is reflected in turn in the rating.

2For some model parameters, the CRA may have an incentive to “deflate” ratings. In such a

case, it labels firms whose economic fundamentals are above the threshold with a rating that

suggests low credit quality, butthe effects on economic efficiency are the same as in the case with

an incentive to inflate ratings. We focus on the case of inflation rather than deflation because

inflation is the phenomenon of interest both empirically and in policy circles.

Credit Rating Inflation and Firms’ Investments 2931

In our view,CRAs’ strategic behavior in the feedback loop is central to under-

standing the effects of CRAs. Given their market power, CRAs are in a unique

position to provide information that affects firm investment decisions and thus

firm credit quality. Indeed, CRAs claim that their ratings are forward-looking,

emphasizing that they are based on the potential impact of foreseeable future

events, which include the effects of the ratings themselves. For example, in

a document that explains its rating process, Moody’s explicitly acknowledges

“the effect of the rating action on the issuer, including the possible effect on

issuer’s market access or conditional obligations,” and that “the level of rating

that Moody’s assigns to an issuer that might experience potential changes in

market access or conditional obligations will reflect Moody’s assessment of the

issuer’s creditworthiness, including such considerations.” Another important

component of the feedback loop is the endogenous firm investment, which de-

termines firm credit quality. The firm’s investment choice thus represents a

moral hazard problem in the model. In the Internet Appendix we show that

if firm credit quality is exogenous, the information provided by credit ratings

always increases economic efficiency.3

In our model, a high rating, even though potentially inflated, provides posi-

tive information to creditors because it implies that the firm does not belong to

the group of particularly low-quality firms, for which the partial verifiability

constraint binds.4Hence, a high rating makes creditors more optimistic about

the firm and more likely to invest in the firm’s bonds, which reduces the firm’s

financial costs and impacts its investment decisions. This is how the ratings

end up having real effects. For those firms for which financial costs are rela-

tively high, the reduction in financial costs leads to inefficient risk-taking, as

lower financial costs allow them to gamble for resurrection and pursue invest-

ments with low expected returns but high potential upside. For firms for which

financial costs are relatively low, the reduction in financial costs provides more

skin in the game, which encourages a shift from high-risk, low-expected-return

investments to low-risk, high-expected-return investments. The implications

for economic efficiency are negative in the first case and positive in the sec-

ond. Hence, the overall effect of the CRA on economic efficiency depends on

the relative strength of these opposing effects. This depends in turn on the

model parameters.

Varying the parameters of the model, we show that the overall expected

real effects of the CRA can be positive or negative. A key result is that the

CRA’s expected real effect is more likely to be negative when the upside of

the risky inefficient investment is high, as a high upside makes gambling for

resurrection more attractive and more likely to follow from a reduction in the

cost of capital.

3The Internet Appendix may be found in the online version of this article.

4Hence, a high credit rating generated by a lax rating strategy is not cheap talk as in Crawford

and Sobel (1982). Due to the partial verifiability constraint, the high rating provides creditors

with a public signal about the firm. The public signal is endogenous and takes a different form

from that in Morris and Shin (2002). In particular, it truncates the supports of creditors’ interim

beliefs from below.