Endogenous Credit Ratings

I study the role of credit ratings in crises by introducing a financial market in a coordination game with borrowers that must rollover their debts. The asset price aggregates dispersed private information acting as a public noisy signal. Credit rating agencies use this price to set their ratings. Moreover, agencies know that credit ratings influence lending decisions, thus affecting the creditworthiness of borrowers. I show that: (a) lenders overreact to changes in prices and credit ratings; (b) credit ratings are inaccurate during crises; (c) regulation relying on credit ratings should be redesigned to suspend their use in crises; (d) in the case of sovereign debt, an international financial institution helps prevent liquidity runs and reduce the negative effects of ratings; (e) transparency in financial markets makes credit ratings more volatile.