Credit Ratings and Investments

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