Models of Credit Ratings Failures

Drawing on the recent theoretical literature on credit rating agencies (CRAs), we provide a simple model that nests the following frictions: conflicts of interest between CRAs and in¬vestors, regulatory reliance on ratings, investor naiveté and opacity in the rating process. These frictions cause ratings in¬flation and selective disclosure that distort the transmission of information from CRAs to investors, resulting in inefficient financing decisions. Rating-contingent regulation and in¬vestor naiveté exacerbate the conflicts of interest, but are nei¬ther necessary nor sufficient for the occurrence of inefficiencies. The model is used to discuss some of the regulatory response to the 2007-2009 financial crisis.