The Design and Business Models of Financial Ratings

A financial intermediary produces information about a firm and is paid either by investors or by the firm being assessed. The funding model determines the type of information produced: investor-paid ratings maximize informativeness about firm fundamentals to increase trading profits, whereas firm-paid ratings combine signals about fundamentals and corporate insiders' effort to strengthen incentives via their effect on market prices. When fundamental uncertainty is sufficiently high, firm-paid ratings achieve time horizon irrelevance: an insider exerts the same effort as under commitment, regardless of his exit horizon. In liquid markets, investor-paid ratings dominate but provide no implicit incentives: bad information drives out good information. The framework sheds light on the funding of credit ratings, the narrow focus of venture capital, and the coexistence of investor-paid and firm-paid ESG information.