A countermeasure designed to restrain self-serving behavior and strategic rating disclosure of credit rating agencies

Abstract

This study examines an incentive of the credit rating agency (CRA) to exert effort to observe projects’ signals and strategically disclose ratings when the upfront fee and performance-based fee scheme are imposed. Under the upfront fee scheme, the CRA obtains an upfront fee in exchange for its services but gains a performance-based fee only if its ratings accurately foresee the rated project’s outcome. In the setting, an issuer solicits a rating from the CRA, whose conduct of inflating and deflating ratings is considered. In addition, the CRA can endogenously exert effort to observe a project's signal, which specifies the signal accuracy and how much operating costs the CRA incurs. After receiving the observed signal, the CRA can strategically decide to announce a rating corresponding to or contradicting the observed signal. The findings reveal that the performance-based fee scheme incentivizes the CRA to exert greater effort and truthfully disclose a more accurate rating.