Abstract
In this paper I develop a model that explains why credit rating agencies classify bonds into coarse categories. The optimal number of categories and their cutoffs are outcomes of profit maximization by a rating agency. The trade-off between the number of issuers that are willing to pay for a rating and how much they are willing to pay determines these optima. The model predicts that rating standards will be tighter during non-crisis periods. It also predicts that new issuer-pay rating agencies will not use finer categories because finer categories provide less incentive for bond issuers to solicit (pay for) a rating. Consistent with the model's prediction, empirical tests show that rating standards are tighter during non-crisis periods.
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