Impact of Pay-for-Performance on Rating Accuracy

Abstract

This study analyses whether the pay-for-performance scheme can encourage Credit Rating Agencies (CRAs) to issue accurate ratings under an investor-pay model. In our model, a CRA individually sets disclosure rules between biased rating and the full disclosure regime; an investor who solicits ratings, decides to acquire information accuracy. The CRA’s information production cost is compensated by a fixed fee, and incentive pay is tied to the portfolio outcome. Finding shows that the pay-for-performance scheme can efficiently motivate the CRA to adopt the full disclosure regime. Sufficiently high information acquisition level requested by the investor and relatively low incentive pay can induce the CRA to fully disclose rating information. The results reveal how the pay-for-performance scheme and the investor’s decision effectively influence the CRA’s behaviour of selecting rating policy.