Investigation of credit rating agency payment scheme to improve profit abilityand rating quality

Abstract

This dissertation aims to examine the impact of incentive compensation mechanism on encouraging credit rating agencies (CRAs) to exert effort in the rating evaluation process and report ratings truthfully. Two analytical studies: one focusing on the CRA’s effort and rating decisions, and the other focusing on the investor’s information acquisition decision and the resulting CRA’s behavior, are conducted.

The first research investigates how a performance-based mechanism can influence the credit rating agency’s behavior of choosing her effort level when conducting a credit rating and announcing a truthful or biased rating based on the observed data. In this setting, the CRA can exert some effort to observe a signal and makes a decision to either truthfully report the rating or biasedly report (deflate or inflate) the rating in presence of the expected reputational loss realized when the rating is inaccurate. Two payment mechanisms: upfront fee and incentive pay are considered. Under the incentive pay scheme, the CRA charges a fixed fee to offset her information production cost and can claim the incentive fee only if the issued rating correctly predicts the outcome of the rated security. Our findings reveal that the incentive pay can encourage the CRA to exert a higher level of effort to produce a credible signal leading to rating accuracy improvement. Furthermore, the incentive pay scheme can more effectively incentivize the CRA to truthfully report the rating that consistently reflects the observed signal, compared to the upfront fee scheme.

The second research investigates the investor’s decision on information acquisition for the rating and the CRA’s decision on the truthfulness of the rating report. Two payment mechanisms: upfront fee and profit-sharing scheme, are considered. The study consists of three main parts: 1) investigation of dynamic interaction between the investor and the CRA, 2) comparison of optimal decisions of the investor and the CRA under the two payment schemes, and 3) decisions on information acquisition of the two types of investors: institutional and marginal investor. In our analysis, the CRA’s behavior of rating policy adoption and the investor’s behavior of requesting additional information accuracy level are characterized. The qualities of credit ratings resulting from the two payment schemes are compared to pinpoint which payment scheme is more effective in improving rating quality.

Ultimately, this dissertation provides key insights for policymakers as well as other agents involved in the credit rating process on how to design efficient payment schemes to improve the accuracy of ratings, and subsequently, the desirable outcome of uncertain financial instruments and projects.