Opacity, Credit Rating Shopping, and Bias

We develop a rational expectations model in which the issuer of a nancial instrument purchases credit ratings(s) in order to provide useful information to investors and attract investor demand. We examine the nature of a credit-rating equilibrium in a staged game in which an issuer purchases rating(s) sequentially and then decides which ratings to disclose. Our analysis emphasizes the importance of opacity about the contacts between the issuer and various rating agencies, leading to potential asymmetric information by investors about which ratings have been obtained. Too many ratings are potentially produced and rating agencies are able to extract rents in equilibrium. While the structure of equilibrium forces the disclosure of ratings when the market knows that these have been produced, in some situations investors are unsure as to whether ratings have been obtained that have not been disclosed. Absent disclosure requirements (the opaque case), ratings bias would arise whenever the equilibrium involves publication of fewer ratings than the number of ratings available to the issuer. However, investors understand the structure of equilibrium and adjust asset pricing to eliminate the potential bias in pricing. The authors wish to thank for helpful comments Anat Admati and participants at presentations of earlier versions of the paper at the Bank of Japan, Carnegie Mellon University, the Federal Reserve Bank of New York, the Financial Intermediation Research Society (Sydney), the London School of Economics, the National Bureau of Economic Research meeting on "The Economics of Credit Rating Agencies," the Norwegian School of Economics and Business Administration (NHH), the Stockholm School of Economics, the University of British Columbia, the University of Iowa and the University of Tokyo. The authors also thank the Sloan Foundation for nancial support. yStockholm School of Economics zCarnegie Mellon University and National Bureau of Economic Research