CFCM 15/04: Credit Rating Agency, Preliminary Ratings and Contact Disclosure

Abstract

A recent amendment to the European Regulation on credit rating agencies requires that they disclose any issuers' request of initial reviews. This paper constructs a model of preliminary ratings and uses it to investigate the effect of contact disclosure. In this setting, the CRA issues a preliminary rating. After receiving this indicative rating, the entrepreneur has the opportunity to either purchase a full report at a cost or to remain unrated. It is shown that when there is no evidence of preliminary contact four types of equilibria can arise. In two of them the entrepreneur ignores the CRA, while in the other two the CRA either issues only positive preliminary or only negative ones and the entrepreneur is responsive to the CRA's opinion. When there is disclosure of the contact between the CRA and the entrepreneur, the CRA ends up acting overconfidently more often and for lower values of the fee. This results in more projects of lower quality, accessing the final rating stage and possibly getting funded. The payoff in the conservative case shrinks because of the reputation term, providing new incentives and causing the behavioural shift.  Allowing for unrated projects partial funding emphasizes even further this tendency.

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Author

Marta Allegra Ronchetti

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