Quality Signalling and Ratings Credibility: Regulatory Reform for the Ratings Industry

Abstract

Financial regulators can enhance the credibility of credit ratings if agencies are offered a registration facility that sequesters part of their fee as a performance bond over a designated maturity. The margin can be responsive to the rating, the defined credit event, and the registration maturity. Agencies can signal their private information by choosing whether or not to register and stake part of their fee. The value of the registration real option determines the amount that is spent by the issuer on the incremental quality of research required. The framework can also inform margin and penalty setting by regulators; while an ex ante choice to register is a potential defence in professional liability litigation.

Keywords: Financial regulation, credit ratings, agency theory, incentive alignment, information value, real option

JEL Classification: G01, G18, G24, G28, G32