Discussion of
“De-Regulating Markets for
Financial Information”
by
Pablo Kurlat and Laura Veldkamp
ASSA Meetings, Chicago IL
January 2012
Jonathan A. Parker
Kellogg School of Management, Northwestern University
Setup
Entrepreneur chooses k, whether to buy rating (D = 0/1), cost C
Expected profit = E[ p | k, D] – k – CD
Investors demand qi(p), whether to buy rating (B = 0/1), cost c
Expected Utility = E[ U(W) | D, B, D, B]
U( ) CARA, W = w0 + qi( f(k) + u – p ) – c B
 = y + n is the rating (k unobserved, rationally inferred)
Ratings agency charges C and c based on cost  and num of buyers
Investors are price takers, rating agency has zero profit condition
Timing: Ratings agency sets costs, Entrepreneur chooses k then D,
Investors choose B then submit demand schedules, Noise traders
arrive, Walrasian auctioneer sets price and allocations in noisy
rational expectations equilibrium
Main results
Ratings may raise or lower the expected payout, but they
always decrease the variance.
Thus private markets get ratings when variance reduction is
most valuable
Information externality for investors use of ratings
Only a fraction of investors may get ratings because
information externality: the more buy, the more
informative prices, and the less need to buy a rating. In
extreme, very informative ratings may not be purchased
Main results
I. Because ratings decrease variance of asset, the
private market will get ratings when
1. Uncertainty about the payout is large enough
2. The rating is informative enough
– The very informative signal may not be gotten by investors due to
revelation in the market (general multiplicity Breon-Drish (2011))
– The Entrepreneur can get a rating for all
3. The cost of the rating is low enough
4. Risk aversion is large enough
5. Risk is systemic enough (few investors Q)
Main results
II. Lack of mandatory ratings tends to reduce asset
prices because without rating, risk is larger. But
only if a) the rating raises price and b) the
private market does not buy anyway. This occurs
for assets with
1. Intermediate numbers of investors
2. Intermediate risky assets
Main results
III. Welfare trades of costs and benefits of information
1. Entrepreneur always prefers no mandated
ratings
2. Because information raises prices, investors
always prefer no information to complete
information, so prefer ban on ratings!
•
Seems functional form/CARA specific
3. But with optional ratings, asymmetric
information can hurt investors, so they may prefer
mandated ratings
Comments
1. The unobservability of k
– Incentive to cheat, which fails in equilibrium, but
gives additional social value to information
– Don’t think you require this and would focus
paper on information externalities without
unobserved effort issues
Comments
2. How important is the risk-neutral entrepreneur?
– It keeps things simple, but it might be a nice extension
to make trade endogenous, since here trade is in
some sense inefficient --- moving risk from riskneutral to risk-averse agents.
– Paper alludes to case in which entrepreneur can keep
some of the project, but I suspect in the present paper
this would be about communicating k to the market
not diversification?
– Distortion of low k due to risk aversion, helped by info
– Welfare would be simpler if all have the same utility
functions
Comments
3. Asset pricing and the role of systemic risk
P(D, D ) = E[M(f(k) + u)|D, D ]
Price increase with public rating:
E[P(1,)–P(0,0)]:=E[Cov [M,f(k)+u]–Cov[M,f(k)+u]]
• Ratings information changes price as it is informative about
covariance with aggregate risk
• No price effect if new information has covariance zero (not
systemic risk) – maybe this is the case for most corporate debt?
• Or maybe key information is about how correlated -- e.g. learning
about the exposure of sub-prime MBS to the cycle
• Or maybe partly about systemic risk itself – e.g. bank or sovereign
debt
• Finally, ratings information reduces price if informative about risk
negatively correlated with systemic risk – asset becomes a worse
hedge
These issues matter because investors other option is only a risk-free
asset
Conclusion
Useful approach to thinking about the benefits
of mandated public provision of ratings
• Cases where the market provides the public
information anyway, where no one provides
the information, the mandate matters
• When the entrepreneur does not provides
public ratings, investors can purchase
• Investor purchases have all the problems with
information acquisition in financial markets