Can Reputation Ensure Efficiency in the Structured Finance Market?

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.