How do credit rating agencies affect firm investments?

"How do credit rating agencies affect firm investments? Credit rating agencies have been criticized for playing a critical role in financial crises (e.g., the 2007 global financial crises) since they tend to inflate credit ratings and, as a result, risky investments get funded and this may lead to negative effects for the economy. However, credit rating agencies do provide some valuable information to investors even if credit ratings are inflated. We analyze a setting with feedback effects: the way investors respond to the rating affects the firm’s investment decision which impacts the firm’s credit quality which is in turn reflected in the credit rating. Theoretical studies show that the overall economic effects of credit rating agencies may be positive or negative depending on the economic environment and on the relationship between information and strategic effects. However, real-market evidence of this mechanism is limited since it is often difficult to isolate the effect of credit ratings on firms’ investments. We plan to conduct a laboratory experiment in order to understand this mechanism. Our experiment will contribute to deepening our understanding of investor behavior and rating inflation in firms’ investments. The experiment consists of several treatments using a between-subject design. In the first treatment, there is no credit rating agency and investors have to take a decision with only private information. In the other treatments, there is a credit rating agency which provides a credit rating (with various degrees of accuracy) to investors. With these treatments we will be able to disentangle the effects of credit rating agencies on firms’ investment decisions and on the overall economy.
This is a joint project with Oana Peia (University College Dublin) and Razvan Vlahu (Central Bank of the Netherlands)."

"How do credit rating agencies affect firm investments? Credit rating agencies have been criticized for playing a critical role in financial crises (e.g., the 2007 global financial crises) since they tend to inflate credit ratings and, as a result, risky investments get funded and this may lead to negative effects for the economy. However, credit rating agencies do provide some valuable information to investors even if credit ratings are inflated. We analyze a setting with feedback effects: the way investors respond to the rating affects the firm’s investment decision which impacts the firm’s credit quality which is in turn reflected in the credit rating. Theoretical studies show that the overall economic effects of credit rating agencies may be positive or negative depending on the economic environment and on the relationship between information and strategic effects. However, real-market evidence of this mechanism is limited since it is often difficult to isolate the effect of credit ratings on firms’ investments. We plan to conduct a laboratory experiment in order to understand this mechanism. Our experiment will contribute to deepening our understanding of investor behavior and rating inflation in firms’ investments. The experiment consists of several treatments using a between-subject design. In the first treatment, there is no credit rating agency and investors have to take a decision with only private information. In the other treatments, there is a credit rating agency which provides a credit rating (with various degrees of accuracy) to investors. With these treatments we will be able to disentangle the effects of credit rating agencies on firms’ investment decisions and on the overall economy.
This is a joint project with Oana Peia (University College Dublin) and Razvan Vlahu (Central Bank of the Netherlands)."