How Issuer-Paid Competition Can Inflate Bond Credit Ratings
Summary
The answer proposes a game-theoretic explanation for possible inflation in bond credit ratings. It assumes that agencies compete for rating work, issuers pay for the service, and issuers prefer agencies that offer higher ratings because those ratings can reduce borrowing costs. Under these assumptions, an agency may have an incentive to rate a bond more generously than its true credit quality warrants in order to win the issuer’s business.
The explanation extends this incentive across agencies: if one offers a higher rating, rivals may respond with still higher ratings, potentially producing an equilibrium where all agencies inflate ratings and issuers select among them without a meaningful rating difference. An agency that gives the lower, more accurate rating risks losing the work. This is a theoretical account, not an empirical demonstration. The document raises the question of whether inflation has occurred but supplies no data or evidence to establish that it has, and its conclusion depends on the stated assumptions about payment and issuer choice.
Key ideas
- Issuer-paid rating agencies may compete for bond rating assignments.
- Issuers can benefit from higher ratings through lower borrowing costs.
- Agencies may offer more favorable ratings to win an issuer’s business.
- If all agencies inflate ratings, an agency that gives a lower rating may lose assignments.
- The answer offers a theoretical mechanism but no empirical evidence that ratings inflation occurred.
Tags
Full text
# Do bond credit ratings suffer from "ratings inflation"? # Do bond credit ratings suffer from "ratings inflation"? A friend of mine who studies game theory suggested that credit ratings from the bond ratings agencies, such as Moody's, S&P, and Fitch, may suffer from a sort of "ratings inflation" similar to the grade inflation seen in many colleges. What are the forces driving grade inflation and how would those same forces apply to bond ratings? Is there any evidence that ratings inflation has taken place? ## Answer by Investeem (score 5, accepted) https://quant.stackexchange.com/a/2783 This is an interesting question. I'll make a guess on what may be the driving factors for "ratings inflation" based on these assumptions: - Rating agencies compete among themselves to conduct bond rating business with issuers, since they are paid for their services by the issuer. - Bond issuers choose the agency that promises the highest rating, since the issuers benefit from having higher ratings through lower costs of debt. Let's suppose one issuer's bond has a true rating of BBB (I adopt S&P's scale) and rating agencies know this. Now each agency may have an incentive to promise an A rating, which is one notch higher, if the benefit from doing so (winning the business) exceeds the cost (harm to reputation if the bond performs poorly). But, then each rating agency may have an incentive to promise an AA if again benefits exceed costs, and so on. To cut the long story short, in this setting, we might have an equilibrium in which all agencies inflate ratings and issuers choose randomly among these agencies. Note that in this equilibrium, if any agency diverges by promising the true rating, which is lower, it loses all of its bond rating business to competitors. Hope this explanation makes sense!
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