ASSA Meetings, Chicago IL January 2012 Jonathan A. Parker

1. 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

2. 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

3. 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

4. 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)

5. 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

6. 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

7. 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

8. 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 risk-neutral 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

9. 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

10. 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