Credit Rating and Competition

Abstract

We develop a theoretical model to analyse the eect of competition on the conflict of interest arising from the issuer pay compensation model of the credit rating industry. We nd that relative to monopoly, rating agencies are more likely to inflate ratings under competition, resulting in lower expected welfare. These results do not depend on the presence of ratings shopping as in Bolton, Freixas, and Shapiro (2012) and Skreta and Veldkamp (2009), but instead focus on the trade-off between maintaining reputation (to increase profits in the future) and in ating ratings today (to increase current profits). Our results suggest that ongoing regulatory initiatives aimed at increasing competition in the ratings industry may reduce overall welfare, unless new entrants have a higher reputation via-a-vis incumbents.

Keywords: Rating agencies, competition, reputation, repeated games, financial regulation

JEL Classification: C73, D43, D82, D83, G24