176 Pages Posted: 14 Jun 2007
Date Written: June 4, 2007
This study provides a comprehensive analysis of credit rating economics and draws conclusions on the nature of regulation. It starts with an overview of the credit rating industry and introduces a framework that structures multiple rating agency functions. At the heart of the credit rating business model lies the reputation mechanism, which is analyzed in detail. Despite several frictions in the process that give rise to entry barriers and market power, the quality assuring function of the reputation mechanism is very robust - contrary to the fear of many.
After analyzing the reputation mechanism, the study takes a wider look at the industry and identifies the forces behind credit rating supply and demand. The structure of demand is dependent on the relation between the 'information value' and the 'license value' attached to ratings because they are used in 'rating-based regulations'. On the supply side the question is whether the high industry concentration is a 'natural' result of market forces or whether it is the result of state interference. Aspects such as economies of scale, switching costs, and market segmentation are discussed. From an industrial organization perspective competition in the credit rating industry is limited.
A comprehensive review of potential reasons for regulating the credit rating industry reveals that there are only few compelling arguments despite the large number of different aspects discussed by practitioners and researchers. In general, the reputation mechanism and competition should be strengthened. Specifically, the study discusses five regulatory areas: the use of rating-based regulation, competition, official recognition, civil liability, and implementation methods. The regulatory approaches of the EU under the Capital Requirements Directive of 2005 and the USA under the Credit Rating Agency Reform Act of 2006 are contrasted against an optimal regulatory regime.
The study closes with a summary and a tabular literature review.
Keywords: Credit Rating Agencies, Credit Rating Industry, Credit Rating Regulation, Credit Rating Agency Reform Act, Capital Requirements Directive
JEL Classification: D40, D82, G00, G20, G38, L00
Suggested Citation: Suggested Citation