Do bond credit ratings suffer from “ratings inflation”?

Question

A friend of mine who studies game theory suggested that credit ratings from the bond ratings agencies, such as Moody's, S&P, and Fitch, may suffer from a sort of "ratings inflation" similar to the grade inflation seen in many colleges. What are the forces driving grade inflation and how would those same forces apply to bond ratings? Is there any evidence that ratings inflation has taken place?

Answer 1

This is an interesting question. I'll make a guess on what may be the driving factors for "ratings inflation" based on these assumptions:

1. Rating agencies compete among themselves to conduct bond rating business with issuers, since they are paid for their services by the issuer.
2. Bond issuers choose the agency that promises the highest rating, since the issuers benefit from having higher ratings through lower costs of debt.

Let's suppose one issuer's bond has a true rating of BBB (I adopt S&P's scale) and rating agencies know this. Now each agency may have an incentive to promise an A rating, which is one notch higher, if the benefit from doing so (winning the business) exceeds the cost (harm to reputation if the bond performs poorly). But, then each rating agency may have an incentive to promise an AA if again benefits exceed costs, and so on.

To cut the long story short, in this setting, we might have an equilibrium in which all agencies inflate ratings and issuers choose randomly among these agencies. Note that in this equilibrium, if any agency diverges by promising the true rating, which is lower, it loses all of its bond rating business to competitors.

Hope this explanation makes sense!