Rating disclosure analysis: compensation reform consequence on counteracting biased credit ratings

Abstract

This study analyzes a compensation reform proposal designed to prevent inaccurate ratings produced by credit rating agencies (CRAs). Specifically, the CRA’s incentive to exert effort to observe the portfolio’s signal and adopt the rating disclosure policy is investigated under the rating-contingent and incentive-based contract. The issuer has a risky portfolio and solicits a rating from the CRA, which endogenously observes a signal and decides on a rating disclosure policy during the rating production process. The findings reveal that the CRA exerts no effort to observe a signal and inflate the rating under the rating contingent contract. Under the incentive-based contract, the CRA always exerts an optimal effort to observe a signal and adopt the full disclosure regime. Hence, the incentive-based contract better incentivizes the CRA to exert more effort to improve rating accuracy and implement the full disclosure policy than the rating contingent contract.

JEL classification:

• G24
• G28
• D82
• D86

Keywords:

• rating contingent fee
• incentive-based fee
• inflated ratings
• deflated ratings

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 The full disclosure regime means that the CRA discloses the rating corresponding with the signal or observed quality of the rated securities. In particular, the CRA announces a high (low) rating when observing a good (bad) signal.

2 The rating deflation regime requires that the CRA always disclose a low rating. More precisely, the CRA assigns a low rating regardless of the observed signal of the portfolio.

3 The rating inflation policy is that the CRA assigns a high rating regardless of the observed signal of the portfolio (Charoontham & Amornpetchkul, 2023, pp. 627–645).

4 CRAs tend to inflate ratings to attract fees from issuers due to issuers’ rating shopping behavior Skreta and Veldkamp (2009, pp. 678–695).

5 The CRA incurs a higher cost when observing a signal of the complex financial products Coval et al. (2009, pp. 3–25) such as mortgage-backed securities, asset-backed securities, etc.