DP11961 | Credit Ratings and Market Information

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How does market information affect credit ratings? How do credit ratings affect market information? We analyze a model in which a credit rating agency's (CRA's) rating is followed by a market for credit risk that provides a public signal - the price. A more accurate rating decreases market informativeness, as it diminishes mispricing and, hence, incentives for investor information acquisition. On the other hand, more-informative trading increases CRA accuracy incentives by making rating inflation more transparent. If the first effect is strong, policies that increase reputational sanctions on CRAs decrease rating inflation, but also decrease the total amount of information.