Credit Rating and Competition

Abstract

In principle, credit rating agencies are supposed to be impartial observers that bridge the gap between private information of issuers and the information available to the wider pool of investors. However, since the 1970s, rating agencies have relied on an issuer-pay model, creating a conflict of interest the largest source of income for the rating agencies are the fees paid by the issuers the rating agencies are supposed to impartially rate. In this paper, we explore the trade-off between reputation and fees and find that relative to monopoly, rating agencies are more prone to inflate ratings under competition, resulting in lower expected welfare. Our results suggest that more competition by itself is undesirable under the current issuer-pay model and will do little to resolve the conflict of interest problem.