Credit Rating Inflation and Firms’ Investment Behavior

Why do potentially inflated credit ratings affect rational, well-informed creditors’ bond investment decisions? What are credit ratings’ effects on firms’ behavior? We resolve these questions by modeling a credit rating agency (CRA) as a certified expert who transmits information to creditors with coordination incentives and dispersed beliefs. In the unique equilibrium, high credit ratings are potentially inflated but serve as public signals that truncate supports of creditors’ posterior beliefs, owing to corporate credit ratings’ partial verifiability. Such public signals change well-informed investors’ decisions, because of their coordination incentives and dispersed beliefs. Depending on the firm’s fundamentals, inflated ratings may mitigate or aggravate the firm’s moral hazard. We show that if the CRA commits to a rating strategy, the optimal committed rating strategy is time-consistent. Both CRAs’ rating standards and credit rating inflation are endogenous in our model, and we show that laxer rating standards are not necessarily accompanied by higher rating inflation. Ultimately, we discuss how certain policies, such as verifying the firm’s investment and providing precise unbiased public signals, can regulate the credit rating industry and mitigate CRAs’ adverse effects.