The Dual Role of Ratings

Raters often collect payments from their ratees. In many markets, the ratee-pays structure sparks controversy on the conventional wisdom that ratings exist to solve adverse selection and moral hazard problems in trades. I prove that ratings tailored to maximize ratees’ payments fully solve moral hazard by leveraging the presence of adverse selection over time. These optimal ratings are coarse and opaque. I find a tension between rating transparency and economic efficiency, illustrate the implications of optimal ratings for market beliefs and behaviors, and reconcile the conventional wisdom with critiques that ratings add little information to the markets.