Abstract
We compare a credit rating agency’s incentives to acquire costly information when it is only paid for giving favorable ratings to the corresponding incentives when the agency is paid up-front, i.e., irrespective of the ratings assigned. We show that, in the presence of moral hazard, contingent fees provide stronger dynamic incentives to acquire information than up-front fees and may induce higher social welfare. When the fee structure is chosen by the agency, contingent fees arise as an equilibrium outcome, in line with the way the market for credit rating actually works. (JEL D21, D82, D83, G24)
Highlights
Credit rating agencies’ (CRAs) principal source of revenue comes from issuers of rated securities, in the form of fees paid only if the issuer chooses to publish the rating obtained.1 To receive any fees, rating agencies are effectively forced to give favorable ratings
As noted by a US Senate report, during the build-up of the financial crisis “neither Moody’s nor S&P hired sufficient staff or devoted sufficient resources to ensure that the initial rating process ... produced accurate credit ratings.”3 The primary goal of our paper is to argue that –in the presence of moral hazard– contingent fees provide stronger dynamic incentives to acquire information than upfront fees and to show that contingent fees can result in more information acquisition and higher social welfare than upfront fees
We focus on Perfect Bayesian Equilibria in which the strategic agency uses a stationary Markov strategy with reputation as the state variable
Summary
Credit rating agencies’ (CRAs) principal source of revenue comes from issuers of rated securities, in the form of fees paid only if the issuer chooses to publish the rating obtained. To receive any fees, rating agencies are effectively forced to give favorable ratings. To tackle the resulting adverse selection problem, several commentators have proposed that issuers instead be required to pay CRAs upfront, that is, independently of whether or not an issuer received a favorable rating.. Produced accurate credit ratings.” The primary goal of our paper is to argue that –in the presence of moral hazard– contingent fees provide stronger dynamic incentives to acquire information than upfront fees and to show that contingent fees can result in more information acquisition and higher social welfare than upfront fees. Whether the agency shirks or acquires information is unobserved by firms and investors. The agency’s choice is between (a) acquiring information to assign a favorable rating if and only if this period’s project is high return, and (b) shirking and assigning a favorable rating automatically. The reputation of the agency is updated based on the accuracy of the last period’s rating
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