Conformity and Competition in Financial Certification

Abstract

This paper examines the reliability of information provided by certification intermediaries, such as rating agencies in the context of both a monopolistic and a duopolistic certification industry. It demonstrates that, in a simple model where the intermediary is concerned about reputation and there is asymmetric information on her ability, the certification intermediary may ignore private information about the quality of the firm and decide instead to conform to the public information. It also shows that an intermediary perceived by the other agents as more talented chooses to act more conservatively by sending unfavourable reports more frequently. However, incentives to send out unfavourable reports and to conform with public information are mitigated by competition in the certification industry. The paper provides a theoretical explanation based on reputational concerns for why a rating agency may exhibit excess sensitivity to the business cycle and for differences in ratings across agencies.