Friday, April 30, 2010

Rating Agencies in the Face of Regulation - Rating Inflation and Regulatory Arbitrage

By Christian C. Opp, Marcus M. Opp and Milton Harris

Abstract: This paper develops a rational expectations model to analyze how rating agencies alter their information acquisition and disclosure policy when ratings are used for regulatory purposes such as bank capital requirements. Although rating agencies generally publish informative ratings, sufficiently large regulatory distortions may lead to a complete break-down of delegated information acquisition - rating agencies merely facilitate regulatory arbitrage by selling inflated ratings to originators. Our model reveals that this result is more likely to occur in complex security classes and how, in general, the impact of regulation on ratings depends on the cross-sectional distribution of borrower types.

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