Confidence, Conflict, and Contagion: Behavioral and Structural Drivers of Inflated Credit Ratings During the Global Financial Crisis.

This research investigates how credit rating agencies (CRAs) contributed to the 2008 Global Financial Crisis (GFC) through the dual influence of structural incentives and behavioral biases. It challenges the traditional view that inflated ratings of mortgage-backed securities and collateralized debt obligations were purely the result of profit-driven manipulation. Instead, it introduces a unified framework that connects institutional conflicts of interest under the issuer-pays model with psychological distortions such as overconfidence, confirmation bias, and herd mentality. Through this lens, the paper explains how seemingly rational market participants systematically underestimated risk, fueling both the housing bubble and the global contagion that followed.

The study integrates theoretical modeling, empirical testing, and simulation analysis. A profit–reputation model formalizes how CRAs maximize short-term revenue while underestimating long-term reputation costs, especially when cognitive distortions reduce sensitivity to uncertainty. This behavioral distortion parameter explains why analysts overrelied on quantitative tools like the Gaussian Copula model, anchoring their risk assessments on outdated or optimistic assumptions. The paper supplements this theoretical framework with tranche-level and rating history data, employing event studies and survival analyses to trace how higher issuer fees, competition, and model dependence correlated with delayed downgrades and inflated AAA ratings.

By bridging structural and behavioral explanations, the research offers a nuanced understanding of how systemic fragility emerged within an ostensibly rational market system. It shows that overconfidence and groupthink were not isolated psychological lapses but were reinforced by institutional design — a dynamic where market competition, weak regulation, and cognitive error amplified one another. The findings underscore the importance of integrating behavioral insight into financial oversight and rating governance, arguing that sustainable reform must address both incentive misalignments and the cognitive limits of decision-makers in complex financial environments.