Abstract
In this paper, we study the optimal credit rating system in an economy where agents need to borrow and have incentives to renege on debt repayments. We show that credit exclusion creates soft collateral in the form of a borrower’s reputation. Compared with individual lending, bank lending reduces search frictions, which increases the cost of credit exclusion, boosts the value of soft collateral, and facilitates borrowing and lending. A dynamic rating system allows agents’ ratings to migrate over time and fine-tunes agents’ incentives. By doing so, it reduces the agency cost, makes better use of soft collateral, and improves social welfare. We show that the optimal rating system is coarse, as we observe in the real world.
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