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The Credit Rating Market - Options for Appropriate Regulation

Author

Listed:
  • Andreas Freytag

    () (Friedrich-Schiller-University Jena and University of Stellenbosch)

  • Martin Zenker

    (Friedrich-Schiller-University Jena, Graduate Programme "Soziale Marktwirtschaft")

Abstract

The principal agent problem is one of the major issues of the credit rating agency market. Is it possible to solve the prevailing incentive problem of the market and contemporaneously satisfy the reputation demand of the investors? This paper presents an option for regulating the credit rating agency market more effectively. The market shall be coordinated through a central allocation office, which is acting as a mediator between both contractual parties. The paper develops a game theoretical approach that considers reputation as one of the most important aspects within the market. After analysing the status quo two policy options are discussed on a game theoretical basis. The main result is that the incorporation of a mediator, which awards the contracts based on a lottery drawing, would help to solve conflicts of interests. The incentive to inflate ratings decreases significantly. Moreover, rating shopping option becomes impossible. Two possible positive side effects for smaller CRAs and new incumbents are the increase of market share as well as reputation. Therefore, the market competition should be affected positively, too.

Suggested Citation

  • Andreas Freytag & Martin Zenker, 2012. "The Credit Rating Market - Options for Appropriate Regulation," Global Financial Markets Working Paper Series 2012-39, Friedrich-Schiller-University Jena.
    • Handle: RePEc:hlj:hljwrp:39-2012
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    File URL: http://pubdb.wiwi.uni-jena.de/pdf/wp_hlj39-2012.pdf
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    References listed on IDEAS

    as
    1. Antoine Faure-Grimaud & Eloïc Peyrache & Lucía Quesada, 2009. "The ownership of ratings," RAND Journal of Economics, RAND Corporation, vol. 40(2), pages 234-257.
    2. Doherty, Neil A. & Kartasheva, Anastasia V. & Phillips, Richard D., 2012. "Information effect of entry into credit ratings market: The case of insurers' ratings," Journal of Financial Economics, Elsevier, vol. 106(2), pages 308-330.
    3. Skreta, Vasiliki & Veldkamp, Laura, 2009. "Ratings shopping and asset complexity: A theory of ratings inflation," Journal of Monetary Economics, Elsevier, vol. 56(5), pages 678-695, July.
    4. Patrick Bolton & Xavier Freixas & Joel Shapiro, 2012. "The Credit Ratings Game," Journal of Finance, American Finance Association, vol. 67(1), pages 85-112, February.
    5. Heski Bar-Isaac & Joel Shapiro, 2011. "Credit Ratings Accuracy and Analyst Incentives," American Economic Review, American Economic Association, vol. 101(3), pages 120-124, May.
    6. 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, vol. 56(5), pages 657-674, July.
    7. Becker, Bo & Milbourn, Todd, 2011. "How did increased competition affect credit ratings?," Journal of Financial Economics, Elsevier, vol. 101(3), pages 493-514, September.
    8. Lawrence J. White, 2010. "Markets: The Credit Rating Agencies," Journal of Economic Perspectives, American Economic Association, vol. 24(2), pages 211-226, Spring.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    credit rating agencies; regulation; reputation; rating inflation; rating shopping;

    JEL classification:

    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • D43 - Microeconomics - - Market Structure, Pricing, and Design - - - Oligopoly and Other Forms of Market Imperfection
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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