The Economics of Investor-Paid Credit Rating Agencies

Abstract

I model direct competition between investor-paid and issuer-paid credit rating agencies (CRAs). Frictions in the form of issuer private benefits induce issuer-paid CRAs to inflate ratings. Investor-paid CRAs optimally generate more accurate ratings, leading to adverse selection for investors that do not purchase these ratings. Yet, rating fees being sunk costs for investors, the endogenous response of issuers and issuer-paid CRAs, and endogenous free-riding by other investors prevent investor-paid ratings from dominating in equilibrium. Consequently, producing investor-paid ratings reduces welfare due to redundant information production. My results conform to several empirical regularities.

Keywords: Credit Rating Agencies, Competition, Regulation, Investor-Paid

JEL Classification: G24, G28, L14