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Fees, Reputation, and Information Production in the Credit Rating Industry†

Fees, Reputation, and Information Production in the Credit Rating Industry† AbstractWe compare a credit rating agency’s incentives to acquire costly information when it is only paid for giving favorable ratings to the corresponding incentives when the agency is paid up-front, i.e., irrespective of the ratings assigned. We show that, in the presence of moral hazard, contingent fees provide stronger dynamic incentives to acquire information than up-front fees and may induce higher social welfare. When the fee structure is chosen by the agency, contingent fees arise as an equilibrium outcome, in line with the way the market for credit rating actually works. (JEL D21, D82, D83, G24) http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png American Economic Journal Microeconomics American Economic Association

Fees, Reputation, and Information Production in the Credit Rating Industry†

Fees, Reputation, and Information Production in the Credit Rating Industry†

American Economic Journal: Microeconomics 2021, 13(2): 1–34 https://doi.org/10.1257/mic.20180170 Fees, Reputation, and Information Production in the Credit Rating Industry By Jacopo Bizzotto and Adrien Vigier* We compare a credit rating agency’s incentives to acquire costly information when it is only paid for giving favorable ratings to the corresponding incentives when the agency is paid up-front, i.e., irre- spective of the ratings assigned. We show that, in the presence of moral hazard, contingent fees provide stronger dynamic incentives to acquire information than up-front fees and may induce higher social welfare. When the fee structure is chosen by the agency, contingent fees arise as an equilibrium outcome, in line with the way the market for credit rating actually works. (JEL D21, D82, D83, G24) redit rating agencies’ (CRAs) principal source of revenue comes from issuers of rated securities, in the form of fees paid only if the issuer chooses to pub- To receive any fees, rating agencies are thus effectively lish the rating obtained. forced to give favorable ratings. Several commentators have proposed that issuers instead be required to pay CRAs up-front (i.e., independently of whether or not an issuer received a favorable rating), the idea being that, with fees paid up-front, However, the difficulty CRAs would no longer have incentives to inflate ratings. to monitor CRAs’ research activities adds a moral hazard dimension to the problem The primary goal of our paper is to argue of regulating the credit rating industry. that contingent fees provide stronger dynamic incentives to acquire information than up-front fees do and to show that, accounting for moral hazard, contingent fees can in fact result in more information acquisition and higher social welfare than up-front fees. We study a CRA rating an infinite sequence of short-li ved firms. Each firm seeks to finance a project with uncertain return. Costly information acquisition...
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Publisher
American Economic Association
Copyright
Copyright © 2021 © American Economic Association
ISSN
1945-7685
DOI
10.1257/mic.20180170
Publisher site
See Article on Publisher Site

Abstract

AbstractWe compare a credit rating agency’s incentives to acquire costly information when it is only paid for giving favorable ratings to the corresponding incentives when the agency is paid up-front, i.e., irrespective of the ratings assigned. We show that, in the presence of moral hazard, contingent fees provide stronger dynamic incentives to acquire information than up-front fees and may induce higher social welfare. When the fee structure is chosen by the agency, contingent fees arise as an equilibrium outcome, in line with the way the market for credit rating actually works. (JEL D21, D82, D83, G24)

Journal

American Economic Journal MicroeconomicsAmerican Economic Association

Published: May 1, 2021

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