Repeated Interaction and Rating In ation: A Model of Double Reputation∗

Financial intermediaries, such as credit rating agencies, have an incentive to maintain a public reputation for credibility amongst investors. However, in a market where credit rating agencies are interacting repeatedly with only a few issuers (sellers), they also have an incentive to develop a second, private reputation for leniency. We develop a dynamic model that analyzes how credit rating agencies can create such a double reputation . A key factor in our model is that issuers have privileged knowledge regarding the quality of rated assets compared to investors. In markets with a repeated interaction between issuers and rating agencies, this information asymmetry leads to di erent reputation updates following each rating process. We show that under certain conditions, it is optimal for the rating agency to in ate ratings as a strategic tool to create a double reputation , whereby investors' beliefs regarding the credibility of the rating agency are higher than those of the issuers. Our results explain why rating in ation occurred speci cally in markets for MBSs and CDOs and not in others. The results suggest that stronger regulation is needed in concentrated markets in order to avoid rating in ation. JEL Classi cation: G24, D82, L15, C73