Financial Reporting and Credit Ratings: On the Effects of Competition in the Rating Industry and Rating Agencies' Gatekeeper Role

Abstract

This paper studies firms' financial reporting incentives in the presence of strategic credit rating agencies and how these incentives are affected by the level of competition in the rating industry and by rating agencies' role as gatekeepers to debt markets. We develop a model featuring an entrepreneur who seeks project financing from a perfectly competitive debt market. After publicly disclosing a financial report, the entrepreneur can purchase credit ratings from rating agencies that strategically choose their rating fees and rating inflation. We derive the following core results. (i) More rating industry competition leads to stronger corporate misreporting incentives if ratings are sufficiently precise or if rating agencies assume a gatekeeper role. Under imperfect rating industry competition, (ii) agencies' gatekeeper role primarily weakens firms' misreporting incentives, which then influences rating agencies' strategies, and (iii) firms' misreporting and rating agencies' rating inflation can be strategic complements when agencies assume a gatekeeper role. (iv) Regulatory initiatives aimed at increasing rating industry competition or at weakening rating agencies' gatekeeper role improve investment efficiency as long as corporate misreporting incentives are not significantly strengthened.