Rating Agencies in the Face of Regulation: Rating Ination and Regulatory Arbitrage

This paper develops a rational expectations framework to analyze how rating agencies’ incentives are altered when ratings are used for regulatory purposes such as bank capital requirements. Regulations of this kind imply that the AAA label of a security is valuable to a regulated investor independent of the information it provides about the riskiness of the security’s underlying cash ‡ows. Our model predicts that a pro…t maximizing rating agency responds to this regulatory environment by partially in‡ating the AAA rating class and by reducing information acquisition relative to a (counter-factual) situation without regulation. The equilibrium precision of a rating trades-o¤ two con‡icting purposes: (a) the reduction of information asymmetries between issuers and investors, and (b) the support of "regulatory arbitrage". Rating in‡ation can be related to regulatory changes that increase the sensitivity of regulations to ratings. In our framework, the issuer-pays model does not cause harm to investors. They rationally anticipate the declining quality of AAA securities but are willing to hold these assets given their relative regulatory bene…ts. Based on our framework we also evaluate the e¤ectiveness of current policy proposals to ban rating contingent fees and reduce rating agencies’ market power. Our model predicts that none of these proposals increase the informativeness of ratings. Keywords: Con‡ict of Interest, Rating In‡ation, Regulatory Arbitrage, Market Discipline, Rating Agencies, Financial Intermediation The authors can be reached at [email protected] and [email protected]. We appreciate helpful discussions with Douglas Diamond, Zhiguo He, Dwight Ja¤ee, Christine Parlour, Steven Tadelis and Adam Szeidl. We also thank Anne Heinrichs for comments on an earlier version of the paper as well as participants of Finance workshops at Princeton University, the University of Chicago (Booth School of Business) and University of California, Berkeley (Haas School of Business). Christian Opp gratefully acknowledges …nancial support from the German National Academic Foundation and the Best Foundation’s 2008 Arnold Zellner Doctoral Prize. Marcus Opp gratefully acknowledges …nancial support through the COR research grant.