The Economics of Solicited and Unsolicited Credit Ratings

In our paper, The Economics of Solicited and Unsolicited Credit Ratings, forthcoming in the Review of Financial Studies, we develop a dynamic rational expectations model to address the question of why rating agencies issue unsolicited credit ratings and why these ratings are, on average, lower than solicited ratings. We analyze the implications of this practice for credit rating standards, rating fees, and social welfare. Our model incorporates three critical elements of the credit rating industry: (i) the rating agencies’ ability to misreport the issuer’s credit quality, (ii) their ability to issue unsolicited ratings, and (iii) their reputational concerns.

We focus on a monopolistic rating agency that interacts with a series of potential issuers that approach the credit market to finance their investment projects. Markets are characterized by asymmetric information in that the firms’ true credit worthiness is private information to the issuers. The credit rating agency evaluates the issuers’ credit quality, that is, their ability to repay investors. It makes these evaluations public by assigning credit ratings to issuers in return for a fee. Issuers agree to pay for these rating services only if they believe that their assigned rating substantially improves the terms at which they can raise capital. This creates an incentive for the rating agency to strategically issue inflated ratings in order to motivate issuers to pay for them. At the same time, investors cannot directly observe the agency’s rating policy. Rather, they use the agency’s past performance, as measured by the debt-repaying records of previously rated issuers, to assess the credibility of its ratings. The agency’s credibility in the eyes of investors is summarized by its “reputation.”

The credit rating agency faces a dynamic trade-off between selling inflated ratings to boost its short-term profit and truthfully revealing the firms’ prospects to improve its long-term reputation. Issuing inflated ratings is costly to the rating agency in the long run, since it increases the likelihood that a highly rated issuer will not be able to repay its debt, thereby damaging the rating agency’s reputation. This, in turn, lowers the credibility of the rating agency’s reports, making them less valuable to issuers and thus reducing the fee that the rating agency can charge for them in the future. The rating agency’s optimal strategy balances higher short-term fees from issuing more favorable reports against higher long-term fees from an improved reputation for high-quality reports. Thus, in our model reputational concerns act as a disciplining device by curbing the agency’s incentive to inflate its ratings. This disciplining effect is, however, limited by the fact that, after a default, investors are not able to perfectly distinguish cases of “bad luck” from cases of “bad ratings” (that is, inflated ratings).

Our analysis shows that the adoption of unsolicited credit ratings increases the rating agency’s short-term profit as well as its long-term profit. This result is driven by two reinforcing effects. First, the ability to issue unsolicited ratings enables the rating agency to charge higher fees for their solicited ratings. The reason is that the rating agency can use its ability to issue unfavorable unsolicited ratings as a credible “threat” that looms over issuers that refuse to pay for its rating services. This threat increases the value of favorable solicited ratings and, hence, the fee that issuers are willing to pay for them.

The credibility of this threat stems from the fact that, by releasing unfavorable unsolicited ratings, the rating agency can demonstrate to investors that it resists the temptation to issue inflated ratings in exchange for a higher fee, which improves its reputation. This second effect, in the form of a reputational benefit, gives the rating agency an incentive to release an unsolicited rating in case an issuer refuses to solicit a rating. Note that this threat is only latent because, in equilibrium, high-quality issuers prefer to acquire favorable solicited ratings. Thus, in equilibrium, the credit rating agency issues unsolicited ratings along with solicited ratings. Since all favorable ratings are solicited, unsolicited credit ratings are lower than solicited ratings. However, they are not downward biased. Rather, they reflect the lower quality of issuers that do not solicit a rating.

The adoption of unsolicited credit ratings also has important welfare implications. We fin d that while rating agencies always benefit from such a policy—because of the higher fees that they can charge—society may not. In particular, we show that, for some parameter values, allowing rating agencies to issue unsolicited ratings leads to less stringent rating standards, thereby enabling more low-quality firms to finance negative NPV projects. This reduces social welfare and raises the cost of capital for high-quality borrowers. Such an outcome is rating agencies should be allowed to issue unsolicited ratings and, thus, to earn higher fees has no unambiguous answer.

Our paper contributes to the growing literature on the role of credit rating agencies and the phenomenon of rating inflation. Mathis, McAndrews, and Rochet (2009) examine the incentives of a credit rating agency to inflate its ratings in a dynamic model of endogenous reputation acquisition. They show that reputational concerns can generate cycles of confidence in which the rating agency builds up its reputation by truthfully revealing its information only to later take advantage of this reputation by issuing inflated ratings. In Bolton, Freixas, and Shapiro (2012), rating inflation emerges from the presence of a sufficiently large number of naive investors who take ratings at face value. Opp, Opp, and Harris (2013) argue that rating inflation may result from regulatory distortions when credit ratings are used for regulatory purposes such as bank capital requirements. Finally, Skreta and Veldkamp (2009) and Sangiorgi and Spatt (2012) focus on “ratings shopping” as an explanation for inflated ratings. While both papers assume that rating agencies truthfully disclose their information to investors, the ability of issuers to shop for favorable ratings introduces an upward bias. In Skreta and Veldkamp (2009), investors do not fully account for this bias, which allows issuers to exploit this winner’s curse fallacy. In contrast, Sangiorgi and Spatt (2012) demonstrate that when investors are rational, shopping-induced rating inflation does not have any adverse consequences. While these papers share some important features with ours, the main contribution of our paper is to explicitly address the effect of unsolicited ratings on the rating policy adopted by credit rating agencies and their impact on rating inflation.

A number of empirical papers have shown that unsolicited ratings are significantly lower than solicited ratings, both in the U.S. market and outside the U.S. These studies explore the reasons for this difference based on two hypotheses. The “self-selection hypothesis” argues that high-quality issuers self-select into the solicited rating group, while low-quality obtained when the increase in rating fees associated with the adoption of unsolicited ratings is sufficiently large so that it outweighs the additional reputational benefit from truthfully revealing the firm’s quality. When this increase in rating fees is small (which happens, for example, when the loss in market value due to an unfavorable unsolicited rating is low), we obtain the opposite result: the ability to issue unsolicited ratings leads to more stringent rating standards, which prevents firms from raising funds for negative NPV investments and, hence, improves social welfare. These results suggest that the question of whether credit issuers self-select into the unsolicited rating group. Under this hypothesis, unsolicited ratings are unbiased, and thus they are not unduly “punitive” to issuing firms. In contrast, the “punishment hypothesis” argues that lower unsolicited ratings are a punishment for issuers that do not pay for rating services and are therefore downward biased. Under this hypothesis, given the same rating level, an issuer whose rating is unsolicited should ex post perform better than one whose rating is solicited.

The findings of these papers provide conflicting evidence. On the one hand, using S&P bond ratings on the international market, Poon (2003) reports that issuers who chose not to obtain rating services from S&P have weaker financial profiles, which is consistent with the “self-selection hypothesis.” Gan (2004) finds no significant difference between the performance of issuers with solicited and unsolicited ratings. This result leads her to reject the “punishment hypothesis” in favor of the “self-selection hypothesis.” On the other hand, Bannier, Behr, and Guttler (2010) cannot reject the “punishment hypothesis” for their sample.

Our paper suggests an alternative explanation for these findings. We show that while unsolicited ratings are lower, they are not the result of rating deflation. Rather, they reflect the lower quality of issuers, as suggested by the self-selection hypothesis. This does not mean, however, that rating agencies cannot use unfavorable unsolicited ratings as a threat in order to pressure issuers to pay higher fees for more favorable ratings. We show that the rating agency’s ability to issue unfavorable unsolicited ratings to high-quality firms can act as a credible punishment even though it may not be carried out in equilibrium and, hence, may not be observed by investors. This happens because, in equilibrium, the rating agency optimally sets the fee that it charges for favorable solicited ratings at a level at which issuers prefer to purchase them rather than risk obtaining unfavorable unsolicited ratings.

The full paper is available for download here.