Credit Rating and Debt Crises

Abstract

We develop an equilibrium theory of credit rating in the presence of rollover risk. By influencing rational creditors, ratings affect sovereigns' probability of default, which in turn affects ratings. Our analysis reveals a pro-cyclical impact of credit rating: In equilibrium the presence of a rating agency increases default risk when it is high and decreases default risk when it is low. *

Credit ratings and liquidity crises

“…Following Holden et al (2018) and Mariano (2012), the present study presents a model in which reputational concerns affect CRAs’ behavior. Reputational capital is important for CRAs because their revenues come from the fees paid by issuers who use CRAs’ reputations to confer credibility on securities.…”

“…Indeed, Carlson and Hale (2006), Goldstein and Huang (2017), and Holden et al (2018) analyze the CRA's role within a global game framework. Carlson and Hale (2006) develop a sovereign debt crisis model with a CRA as an application of the global game methodology.…”

“…However, they assume that the CRA only passes its information on to the market, so they do not consider any CRA strategic behavior. Holden et al (2018) study how a strategic CRA reinforces sovereigns’ probability of default and reveals a pro‐cyclical impact of credit ratings. Goldstein and Huang (2017) analyze credit ratings’ effects on a firm's investment, which in turn can affect creditors’ debt rollover decisions and eventually credit ratings.…”

“…To analytically examine the effects of information structure on the CRA's behavior, we develop a model based on Carlson and Hale (2006) and Holden et al (2018). The CRA disseminates its signal to creditors, but the CRA has reputational incentives in our model.…”

Credit Rating Inflation and Firms' Investments

“…For example, Sufi (2009) finds that introducing bank loan ratings increases firms' asset growth, cash acquisitions, and investment in working capital; Bannier, Hirsch, and Wiemann (2012) show that firms reduce (raise) their investment rates around negative (positive) rating events; and Almeida et al (2017) find that firms reduce their investment due to an increased cost of debt capital following a sovereign rating downgrade. While such real effects are largely absent in theoretical models of credit ratings, several previous papers introduce different forms of feedback, in particular Boot, Milbourn, and Schmeits (2006), Manso (2013), Goel and Thakor (2015), and Holden, Natvik, and Vigier (2018). A key difference between our study and these previous papers is that in our model the real effect is a result of information transmission from the rating agency to creditors, whereas in these papers it is a result of changing the focal point for equilibrium selection, contractual features that affect the firm when the rating changes, or the CRA's incentives to balance the issuer's payoff and social welfare.…”