Who Should Pay for Credit Ratings and How?

Abstract

We analyze a model where investors use a credit rating to decide whether to finance a firm. The rating quality depends on unobservable effort exerted by a credit rating agency (CRA). We study optimal compensation schemes for the CRA when a planner, the firm, or investors order the rating. Rating errors are larger when the firm orders it than when investors do (and both produce larger errors than is socially optimal). Investors overuse ratings relative to the firm or planner. A tradeoff in providing time-consistent incentives embedded in the optimal compensation structure makes the CRA slow to acknowledge mistakes. (JEL: D82, D83, D86, G24)We have benefited from suggestions and comments by the editor, two anonymous referees,

Securitization, Ratings, and Credit Supply

“…Thus, incorporating these considerations has an effect similar to a reduction in the accuracy of (exogenously generated) ratings. 6 Important considerations include the role of CRA reputation and moral hazard (Mathis, McAndrews, and Rochet (2009), Bar-Isaac and Shapiro (2013), Fulghieri, Strobl, and Xia (2014), Goel and Thakor (2015), Kashyap and Kovrijnykh (2015)), feedback effects and ratings as coordination devices (Boot, Milbourn, and Schmeits (2006), Manso (2013), Goldstein and Huang (2017)), and the implications of rating-contingent regulation (Opp, Opp, and Harris (2013), Josephson and Shapiro (2019)). 7 See http://faculty.haas.berkeley.edu/bgreen/files/RatingsWP2017.pdf.…”

Fees, Reputation, and Information Production in the Credit Rating Industry

“…Our paper builds on the work of Mathis, McAndrews and Rochet (2009) showing that when fees are contingent then reputational concerns are typically insufficient to discipline rating agencies. The effects of reputational concerns in the credit rating industry are further analyzed in five recent papers : Fulghieri, Strobl and Xia (2014), Frenkel (2015), Kashyap and Kovrijnykh (2016), Bouvard and Levy (2018) and Kovbasyuk (2018). Fulghieri et al (2014) analyze the effect of introducing unsolicited credit ratings on CRAs' behavior in a model with contingent fees.…”

“…The agency thus aims for a balanced reputation. The fee structure of CRAs is endogenized in both Kashyap and Kovrijnykh (2016) and Kovbasyuk (2018). In Kashyap and Kovrijnykh (2016) the focus is on who should pay for the ratings.…”

“…The fee structure of CRAs is endogenized in both Kashyap and Kovrijnykh (2016) and Kovbasyuk (2018). In Kashyap and Kovrijnykh (2016) the focus is on who should pay for the ratings. The authors find that rating errors tend to be larger in the issuer-pays models than in the investor-pays model.…”

Predicting Financial Health of Banks for Investor Guidance Using Machine Learning Algorithms

“…Credit rating agencies provide guidance to the deposit holders, to a certain extent. However, virtually every government inquiry into the 2008–2009 global financial crisis has assigned some blame to credit rating agencies for assigning inaccurate ratings and errors (Kashyap & Kovrijnykh, 2015). Recently, India’s credit rating agencies have come under severe scrutiny over their sudden downgrading of one of the country’s largest non-banking financial institution, Infrastructure Finance and Leasing Corporation (IL&FS).…”