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Review of Financial Studies 2006 19(1):81-118; doi:10.1093/rfs/hhj009
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© The Author 2005. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org.

Credit Ratings as Coordination Mechanisms

Arnoud W. A. Boot
University of Amsterdam and CEPR

Todd T. Milbourn
Washington University in St. Louis

Anjolein Schmeits
New York University

Address correspondence to Arnoud W. A. Boot, University of Amsterdam, Roetersstraat 11, 1018 WB Amsterdam, The Netherlands, or e-mail: a.w.a.boot{at}uva.nl.

In this article, we provide a novel rationale for credit ratings. The rationale that we propose is that credit ratings serve as a coordinating mechanism in situations where multiple equilibria can obtain. We show that credit ratings provide a "focal point" for firms and their investors, and explore the vital, but previously overlooked implicit contractual relationship between a credit rating agency (CRA) and a firm through its credit watch procedures. Credit ratings can help fix the desired equilibrium and as such play an economically meaningful role. Our model provides several empirical predictions and insights regarding the expected price impact of rating changes.


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