TITLE:
Can Reputation Ensure Efficiency in the Structured Finance Market?
AUTHORS:
Mahmoud Elamin
KEYWORDS:
Credit Rating Agencies, Conflicts of Interest, Reputation
JOURNAL NAME:
Theoretical Economics Letters,
Vol.7 No.1,
January
10,
2017
ABSTRACT: Structured finance products are opaque and their
ratings are unverifiable. Therefore, a credit rating agency (CRA) cannot
credibly fully reveal its information about the quality of a rated structured
finance project. Can reputation discipline the CRA? I introduce incomplete
information about the CRA’s type: With some probability, it is a truthful type
that always fully reveals its information. The (updated) probability that the
CRA is truthful is its reputation. With only two project types and when the CRA’s
reputation is high enough, an informationally-efficient equilibrium, where
investors are fully informed, exists. If firms know the true CRA type however,
this existence result fails. Moreover, with more than two project types, no
matter how high the CRA’s patience level or its reputation, there is no
informationally-efficient equilibrium. The many project types case is clearly
the relevant case. Therefore, I conclude that the fear to lose reputation is
not enough deterrent in the structured finance market.