Chapter 8: Wrong incentives in the credit rating industry
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CRAs’ conflicts of interest are particularly acute in the structured finance segment. Since the 1970s the rating industry has shifted from an investor-pays business model to an issuer-pays business model. CRAs could no longer count on investors to pay for credit ratings. This is partly based on the fact that information is a public good. Due to the public-good nature of ratings, it is hard to get any individual investor to pay for ratings. It is worth mentioning that communication technology has changed dramatically since the creation of the rating industry in 1909. Above all, since the 1970s, low-cost photocopying explains why investors are not willing to pay for information that can easily be spread. Information economics theory highlights the fact that ratings are hard to sell to investors. The equilibrium selling price for rating information is zero. In fact, each recipient of a rating could secretly sell the information to other investors for a somewhat lower price until the price for the rating information falls to zero. From another perspective, less reliance on the CRAs to provide valuable information may partly have moved investors away from ratings. In order to be profitable, CRAs had to rely on another source of revenue and they started being paid by the issuers. Accordingly, in modern financial markets one reason for CRAs’ profitability is the issuers’ strong demand for ratings. Currently, conflicts of interest have been particularly acute since the vast majority of the leading CRAs’ revenues are from issuers’ fees.

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