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Ratings Quality over the Business Cycle

By Heski Bar-isaac and Joel Shapiro

Abstract

The reduced accuracy of credit ratings on structured …nance products in the boom just preceding the …nancial crisis has prompted investigation into the business of Credit Rating Agencies (CRAs). While CRAs have long held that their behavior is disciplined by reputational concerns, the value of reputation depends on economic fundamentals that vary over the business cycle. These include income from fees, default probabilities for the securities rated, competition in the labor market for analysts, and expectations about the future. We analyze a dynamic model of ratings where reputation is endogenous and the market environment may vary over time. We …nd that a CRA is more likely to issue less accurate ratings in boom times than during recessionary periods. Persistence in economic conditions can diminish our results, while mean reversion exacerbates them. yields similar qualitative results. Finally, we demonstrate that competition among CRA

Topics: Credit rating agencies, reputation, ratings accuracy JEL Codes, G24, L14
Year: 2010
OAI identifier: oai:CiteSeerX.psu:10.1.1.372.6154
Provided by: CiteSeerX
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