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Who Should Pay for Credit Ratings and How?

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  • Anil K Kashyap
  • Natalia Kovrijnykh

Abstract

This paper analyzes a model where investors use a credit rating to decide whether to finance a firm. The rating quality depends on the unobservable effort exerted by a credit rating agency (CRA). We analyze optimal compensation schemes for the CRA that differ depending on whether a social planner, the firm, or investors order the rating. We find that rating errors are larger when the firm orders it than when investors do. However, investors ask for ratings inefficiently often. Which arrangement leads to a higher social surplus depends on the agents' prior beliefs about the project quality. We also show that competition among CRAs causes them to reduce their fees, put in less effort, and thus leads to less accurate ratings. Rating quality also tends to be lower for new securities. Finally, we find that optimal contracts that provide incentives for both initial ratings and their subsequent revisions can lead the CRA to be slow to acknowledge mistakes.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18923.

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Date of creation: Mar 2013
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Handle: RePEc:nbr:nberwo:18923

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  1. Yeon-Koo Che & Seung-Weon Yoo, 2001. "Optimal Incentives for Teams," American Economic Review, American Economic Association, American Economic Association, vol. 91(3), pages 525-541, June.
  2. Faure-Grimaud, Antoine & Peyrache, Eloïc & Quesada, Lucía, 2005. "The Ownership of Ratings," CEPR Discussion Papers, C.E.P.R. Discussion Papers 5432, C.E.P.R. Discussion Papers.
  3. Donald P. Morgan, 2002. "Rating Banks: Risk and Uncertainty in an Opaque Industry," American Economic Review, American Economic Association, American Economic Association, vol. 92(4), pages 874-888, September.
  4. Mathis, Jérôme & McAndrews, James & Rochet, Jean-Charles, 2009. "Rating the raters: Are reputation concerns powerful enough to discipline rating agencies?," Journal of Monetary Economics, Elsevier, Elsevier, vol. 56(5), pages 657-674, July.
  5. Bar-Isaac, Heski & Shapiro, Joel, 2013. "Ratings quality over the business cycle," Journal of Financial Economics, Elsevier, Elsevier, vol. 108(1), pages 62-78.
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Cited by:
  1. Lawrence J. White, 2013. "Credit Rating Agencies: An Overview," Annual Review of Financial Economics, Annual Reviews, Annual Reviews, vol. 5(1), pages 93-122, November.

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