Credible Ratings

This paper considers a model of a rating agency with multiple clients, in which each client has a separate market that forms a belief about the quality of the client after the agency issues a rating. When the clients are rated separately (individual rating), the credibility of a good rating is limited by the incentive of the agency to exaggerate the quality of its client. In centralized rating, the agency rates all clients together and shares the rating information among all markets. This allows the agency to coordinate the ratings and achieve a higher average level of credibility than in individual rating. In decentralized rating, the ratings are again shared among all markets, but each client is rated by a self-interested rater of the agency with no access to the quality information of other clients. When the underlying qualities of the clients are correlated, decentralized rating leads to a smaller degree of rating inflation and hence a greater level of credibility than in individual rating. Centralized rating dominates decentralized rating for the agency when the underlying qualities are weakly correlated, but the reverse holds when the qualities are strongly correlated. Acknowledgment: Part of the research was conducted when Damiano and Li visited Suen at the University of Hong Kong. We thank the University for its hospitality and the Hong Kong Institute of Economics and Business Strategy for research support. We also benefited from seminar audiences at University of Amsterdam, University of British Columbia, Duke University, ECARE, Erasmus University, Peking University, Shanghai University of Finance and Economics, Singapore Economic Theory Workshop, Tsinghua University and University of Toronto. We also thank the Editor and two anonymous referees for many helpful suggestions.