Working Paper: NBER ID: w18923
Authors: Anil K. Kashyap; Natalia Kovrijnykh
Abstract: We analyze a model where investors use a credit rating to decide whether to finance a firm. The rating quality depends on unobservable effort exerted by a credit rating agency (CRA). We study optimal compensation schemes for the CRA when a planner, the firm, or investors order the rating. Rating errors are larger when the firm orders it than when investors do (and both produce larger errors than is socially optimal). Investors overuse ratings relative to the firm or planner. A trade-off in providing time-consistent incentives embedded in the optimal compensation structure makes the CRA slow to acknowledge mistakes.
Keywords: credit ratings; credit rating agencies; financial crisis; compensation schemes; issuer-pays model; investor-pays model
JEL Codes: D82; D83; D86; G24
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| party ordering the rating (G24) | quality of the rating produced (C52) |
| issuer-pays model (G24) | CRA effort (H26) |
| CRA effort (H26) | rating accuracy (C52) |
| payment model (J33) | reliance on ratings (G24) |
| competition among CRAs (G24) | rating accuracy (C52) |
| effort exerted by CRA (H26) | accuracy of the ratings produced (C52) |
| structure of compensation (M52) | CRA's willingness to acknowledge mistakes (H26) |