Skin-in-the-game in Credit Ratings
|This paper, addresses the agency problems between credit rating agencies
(CRAs) and investors, resulting from the issuer-pays-model. Because of barriers to entry and absence of liability, CRAs can only be incentivized to rate accurately by reputation. This allows for implicit cartels and high social costs of punishing abuse. Investors, however, can easily issue credible ratings because of their co-investments.
Allowing investors issued ratings introduces competition that can enhance the disciplining effect of CRA reputation while reducing fees and making ratings widely available. Allowing investor ratings also lowers social costs of punishing CRAs. These effects are enhanced if investors perform simple preliminary screenings, as CRA abuse is easier identified. Convex investor compensation weakens investor incentives.
Finally, without excess profits, CRAs cannot commit to accurate ratings.
|The Brown Bag Seminars are sponsored by ERIM.|