Ratings as regulatory stamps

• I examine the accuracy implications of rating-contingent regulation.
• Regulatory reliance on ratings reduces accuracy of ratings.
• Rating inflation is more likely for complex financial securities.
• Regulatory reliance on ratings expands the class of assets where rating inflation occurs.

This paper analyzes the implications of the regulatory benefits that the investors derive from holding highly rated securities for a credit rating agency's (CRA) rating policy. The CRA's endogenous rating fee is shown to be decreasing in the accuracy of the rating. The CRA provides a rating only when the investors’ regulatory benefit exceeds a minimum threshold. The regulatory reliance on ratings unambiguously reduces rating quality. Strategic rating inflation is more likely for complex financial securities with high fixed evaluation costs, and regulatory reliance on ratings expands the class of assets where rating inflation can occur. The ratings solicited by issuers who are more exposed to negative balance sheet shocks are more likely to be inaccurately optimistic.