Choice of rating technology and loan pricing in imperfect credit markets

Abstract

Accurate rating systems are of central importance for banks to price and manage their loan portfolios. A bank's choice to invest in a more accurate rating technology is based on a trade-off: the better rating system usually comes at higher cost, but endows the bank with a competitive advantage, which includes potentially better access to funds. This paper models the rating technology choice of a bank as a two-stage game in an oligopolistic banking sector. In the first stage banks choose between two alternative rating technologies that provide estimates about a borrower's default probability with varying precision. In the second stage banks set their loan prices based on estimated default probabilities in an imperfectly competitive loan market. While rating technology investment is lumpy and characterized by fixed costs, loan prices vary continuously with their markup over the risk-free rate of interest. The interaction of loan pricing and rating technology investment gives rise to the following predictions: equilibrium adoption of the new rating technology need not increase individual banks' profits; identical banks in a symmetric banking sector might adopt the more accurate rating technologies sequentially rather than simultaneously; and increased competition in the banking sector slows investment in the new rating technology.