Rating deflation versus inflation: On procyclical credit ratings

This article provides a theoretical analysis to reconcile the controversy between rating deflation versus inflation. In our model, the credit rating agency trades off between the current incomes paid by the issuer upon receiving a favorable rating and the future reputation costs. We show that both rating deflation and rating inflation can occur in equilibrium. Furthermore, credit ratings are procyclical since the probability of default is higher and thus the reputation costs are higher during recessions than during booms.