The Economics of Unsolicited Credit Ratings

The role of credit rating agencies as information producers has attracted considerable attention during the recent financial crisis. In this paper, we develop a dynamic rational expectations model to examine the credit rating process, incorporating three critical elements of this industry: (i) the rating agencies’ ability to misreport the issuer’s credit quality, (ii) their ability to issue unsolicited ratings, and (iii) their reputational concerns. We analyze the incentives of credit rating agencies to issue unsolicited credit ratings and the effects of this practice on the agencies’ rating strategies. We find that the issuance of unsolicited credit ratings enables rating agencies to extract higher fees from issuers by credibly threatening to punish issuers that refuse to solicit a rating with an unfavorable unsolicited rating. This policy also increases the rating agencies’ reputation by demonstrating to investors that they resist the temptation to issue inflated ratings. In equilibrium, unsolicited credit ratings are lower than solicited ratings, because all favorable ratings are solicited; however, they do not have a downward bias. We show that, under certain economic conditions, a credit rating system that incorporates unsolicited ratings is beneficial in the sense that it leads to more stringent rating standards and improves social welfare. JEL classification: D82, G24