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Credit Ratings and Investments

Working paper 776
Working Papers
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Published: 16 May 2023

By: Anna Bayona Oana Peia Razvan Vlahu

We study how inflated credit ratings affect investment decisions in bond markets using experimental coordination games. Theoretical models that feature a feedback effect between capital markets and the real economy suggest that inflated ratings can have both positive and negative real effects. We compare markets with and without a credit rating agency and find that ratings significantly impact investor behaviour and capital allocation to firms. We show that the main mechanism through which these real effects materialize is a shift in investors’ beliefs about the behaviour of other investors rather than firms’ underlying fundamentals. Our experimental results sug- gest that the positive impact of inflated ratings is likely to dominate in the presence of feedback effects since ratings act as a strong coordination mechanism resulting in enhanced market outcomes.

Keywords: Credit ratings; Imperfect information; Investor beliefs; Firm financing
JEL codes D81; D82; D83; G24

Working paper no. 776

776 - Credit Ratings and Investments

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Research highlights:

  • We study how inflated credit ratings affect investment decisions in bond markets.
  • We present a theoretical model that features a feedback effect between capital markets and the real economy to highlight the positive and negative effects of inflated ratings.
  • Using experimental coordination games, we compare markets with and without a credit rating agency to test the theoretical predictions of the model empirically.
  • We find that ratings significantly impact investor behaviour and capital allocation to firms. The main mechanism through which these real effects materialize is a shift in investors' beliefs about the behaviour of other investors rather than firms' underlying fundamentals.
  • Our experimental results suggest that the positive impact of inflated ratings is likely to dominate in the presence of feedback effects since ratings act as a strong coordination mechanism resulting in enhanced market outcomes.

 

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