Compensation reform analysis on inflated credit rating attenuation

This study investigates the impact of compensation schemes on the decisions of a credit rating agencies (CRA) regarding how much effort to exert when learning about the type of a portfolio and how to disclose the learned information in the form of credit rating. Two compensation schemes are considered: (i) the rating contingent fee scheme, under which the fee is paid only when a favorable rating is provided, and (ii) the outcome contingent fee scheme, under which the fee is paid only when the rating accurately predicts the true type of the portfolio. The CRA’s optimal effort exertion level and disclosure policy selection when offered each type of compensation schemes are characterized, taking into account the possibility of inflating ratings as well as the reputational cost from misreporting ratings. Our findings reveal that when the CRA is paid a rating contingent fee, it may strategically inflate ratings if the reputational cost is minimal. In contrast, when the CRA receives an outcome contingent fee, it always exerts the optimal level of effort to produce a credible signal and reports ratings truthfully. Hence, the outcome contingent fee scheme has potential to reduce the incidents of inflated credit ratings perceived as a radical cause of financial crises.