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Imperfect Information Transmission from Banks to Investors: Macroeconomic Implications

We study the interaction of information transmission in loan-backed asset markets and screening effort in a general equilibrium framework. Originating banks can screen their borrowers, but can inform investors of their asset type only through an error-prone rating technology. The premium paid on highly rated assets emerges as the main determinant of screening effort. Because the rating technology is imperfect, this premium is insufficient to induce the efficient level of screening. However, the fact that banks know their asset quality and produce public information accordingly helps keep the premium high. Mandatory rating and mandatory ratings disclosure policies interfere with this decision margin, thereby reducing informativeness of high ratings, lowering the premium paid on them, and exacerbating the credit misallocation problem. Policies that work to increase accuracy and/or cost of rating technology can help restore efficiency. If, as in Skreta and Veldkamp (2009), we associate the expansion leading up to the recent financial crisis with declining rating accuracy, our model helps interpret several puzzling pre-crisis observations: laxer screening effort, intensified rating activity, ratings inflation, the decline in the premium paid on highly rated assets, and rising prevalence of triple-A ratings. The same model mechanism also helps explain the variation in default rates across asset classes documented in Cornaggia, Cornaggia, and Hund (2017).

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https://doi.org/10.20955/wp.2018.018


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