We analyze credit ratings’ effects on firms’ investments in a rational debt-rollover game that features a feedback loop. The credit rating agency (CRA) has an inherent incentive to inflate the rating, providing a biased but informative signal to investors. Investors’ response to the rating affects the firm’s cost of capital, investment decision, and credit quality, and this is reflected in the initial rating. The CRA might reduce ex-ante economic efficiency, and this comes solely as a result of the feedback effect of the rating: The CRA understands the effect of the information it provides and allows more firms to gamble for resurrection. We derive empirical predictions on the determinants of rating standards and rating inflation, and discuss policy that could potentially avoid the inefficiency.

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