Exploring the informational role of inflated credit ratings

Recent theoretical models show that inflated credit ratings can have both negative and positive real effects due to the feedback effect between capital markets and the real economy. This feedback effect occurs because ratings not only reflect firms’ creditworthiness but can also affect it by influencing firms’ access to credit. However, testing the real effects of inflated ratings is empirically challenging. Therefore, this paper proposes a laboratory experiment to examine how inflated credit ratings influence investment decisions in bond markets. By comparing markets with and without a credit rating agency, we find that ratings significantly impact investor behaviour and capital allocation to firms. Our research highlights that the primary mechanism behind these effects is a shift in investors’ beliefs about their peers’ behaviour rather than firms’ underlying fundamentals. Overall, our experimental results indicate that inflated credit ratings act as a strong coordination mechanism, resulting in enhanced market outcomes, with the positive impact likely prevailing in the presence of feedback effects.