Can a Platform-Pays Mechanism Reduce Credit Ratings Bias?

Abstract

We show that a platform-pays mechanism can address ratings inflation and ratings shopping with minimum regulatory oversight. While we focus on ratings industry, the mechanism also applies to a setting where firms seek unbiased reports from external auditors. The mechanism has two necessary and sufficient features: strategic delegation and outcome-contingent contracts. First, an issuer strategically delegates the task to acquire ratings from credit ratings agencies (CRAs) to a pass-through non-monitoring platform (the "trust"). The trust operates as a commitment mechanism, assuring investors that issuers did not shop for ratings. Second, the ex-ante determined publicly available fees schedule is partially outcome-contingent, allowing most of the fees to be paid upfront. We provide the contractual space of fees that support the unbiased ratings equilibrium. A contract calibrated to data shows that the cost of implementation of such a mechanism is small. Results encourage policymakers to undertake reforms.

Keywords: Platform-Pays, Ratings Inflation, Ratings Shopping, Rating Agencies

JEL Classification: D82, G14, G24, G28