The Trust Alternative

Abstract

We propose an alternative market design to the current credit ratings industrial organization. An issuer delegates a pass-through non-monitoring trust to acquire ratings from credit ratings agencies (CRAs). The trust pays outcome contingent fees, which ensure that truth-telling is incentive compatible for CRAs, thus eliminating ratings ination. Because it is appointed and funded by the issuers before ratings are published, the trust also removes the ability of issuers to shop for better ratings. The existence of the trust, therefore, leads to more accurate ratings, which in turn attract more investors to the market. The surplus created by increased participation is used to ensures voluntary participation of both issuers and CRAs, thus making the trust a Pareto-improving choice for all the players involved. Finally, the trust mechanism leads to an equilibrium where competition among CRAs create welfare enhancement, as opposed to destroy it. Through a system of outcome contingent payments, the trust can in fact induce CRAs to exert eort and compete with each other for the production of the most accurate rating.