Credit Ratings as Coordination Mechanisms

Arnoud W. A. Boot; Todd T. Milbourn; Anjolein Schmeits

doi:10.1093/rfs/hhj009

Credit Ratings as Coordination Mechanisms

Arnoud W. A. Boot^1,2; Todd T. Milbourn³; Anjolein Schmeits⁴

¹ University of Amsterdam · ² Center for Economic and Policy Research · ³ Washington University in St. Louis · ⁴ New York University

Review of Financial Studies 2006 open access

In this article, we provide a novel rationale for credit ratings. The rationale that we propose is that credit ratings serve as a coordinating mechanism in situations where multiple equilibria can obtain. We show that credit ratings provide a “focal point” for firms and their investors, and explore the vital, but previously overlooked implicit contractual relationship between a credit rating agency (CRA) and a firm through its credit watch procedures. Credit ratings can help fix the desired equilibrium and as such play an economically meaningful role. Our model provides several empirical predictions and insights regarding the expected price impact of rating changes.

DOI: 10.1093/rfs/hhj009
Volume: 19 (1)
Pages: 81-118
Language: en
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