Put Credit Rating Agency's Money Where Its Mouth Is

Abstract

We derive an optimal compensation contract that incentivizes credit rating agency (CRA) to exert effort and issue unbiased ratings. Under the optimal contract, CRA is not paid directly. Instead, CRA is given an opportunity to profit from its superior knowledge about future bond performance. The optimal contract can be implemented by giving CRA options to buy bonds or credit default swaps. In a competitive environment, the contract is part of a procurement auction. Our empirical findings show that the credit rating industry with its current upfront fee compensation structure remains problematic. Compared to incumbent CRAs, new entrants consistently issue more favorable ratings and are willing to rate more CMBS tranches.

Keywords: Credit Rating, Information Acquisition, Moral Hazard, Optimal Contracting

JEL Classification: G24, D86