Put Credit Rating Agency's Money Where Its Mouth Is

44 Pages Posted: 27 Dec 2021 Last revised: 13 Jan 2022

See all articles by Ping Liu

Ping Liu

Krannert School of Management, Purdue University

Alexei Tchistyi

Cornell SC Johnson College of Business

Date Written: December 23, 2021

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

Suggested Citation

Liu, Ping and Tchistyi, Alexei, Put Credit Rating Agency's Money Where Its Mouth Is (December 23, 2021). Available at SSRN: https://ssrn.com/abstract=3992776 or http://dx.doi.org/10.2139/ssrn.3992776

Ping Liu (Contact Author)

Krannert School of Management, Purdue University ( email )

1310 Krannert Building
West Lafayette, IN 47907-1310
United States
7654944691 (Phone)

Alexei Tchistyi

Cornell SC Johnson College of Business ( email )

Ithaca, NY 14850
United States

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