Precision of Ratings

Building on the idea that precision of credit ratings matters for the efficiency of investors' portfolio decisions, the paper analyzes the equilibrium precision of ratings. Our analysis explains why ratings are noisy, exhibit rating inflation and vary across asset classes and over the economic cycle. It also reveals that a laissez-faire CRA provides socially inefficient rating precision and that precision of ratings is further reduced by costly information acquisition. The model is applied to evaluate the post-crisis policy proposals of regulation of CRAs. It explains how CRA response to some but not all regulations can further reduce market efficiency