On Duopoly and Compensation Games in the Credit Rating Industry

52 Pages Posted: 16 Oct 2012 Last revised: 22 Sep 2015

See all articles by Robert J. Rhee

Robert J. Rhee

University of Florida Levin College of Law

Date Written: 2013

Abstract

Credit rating agencies are important institutions of the global capital markets. If they had performed properly, the financial crisis of 2008-2009 would not have occurred, and the course of world history would have been different. There is a near universal consensus that reform is needed, but none as to the best approach. The problem has not been solved. This Article offers the simplest fix proposed thus far, and it is contrarian. Unlike other reform proposals, this Article accepts the central role of rating agencies in the regulation of bond investments, the realities of a duopoly, and the issuer-pay model of compensation. The status quo is the baseline. While not ideal, this much-maligned state is still well suited for robust competition leading to more accurate credit ratings. The role of regulation should be to create the conditions necessary to induce competition. This Article proposes that a small, recurring portion of revenue earned by the largest rating agencies should be ceded to fund a pay-for-performance bonus, and that the agencies should compete for this bonus on a periodic winner-take-all basis. This modest, at the margin bonding mechanism would have significant effects on incentives and outcomes: conflict of interest and implicit coordination would be minimized; competition would increase; the quality of ratings would improve. Furthermore, this funding scheme can promote the incubation of smaller new competitors through a program of “shadow competition” creating a competitive information market on credit ratings. Since regulation would only be required to assess performance, and would not change the fundamental industrial organization, this proposal has the advantage of simplicity and feasibility.

Keywords: credit rating agencies, Moody’s, Standard & Poor’s, Fitch, Dodd-Frank, financial regulation

JEL Classification: D2, D4, G18, G2, G38, K1, K2, l00, l1, l2

Suggested Citation

Rhee, Robert J., On Duopoly and Compensation Games in the Credit Rating Industry (2013). Northwestern University Law Review, Vol. 108, 2013, U of Maryland Legal Studies Research Paper No. 2012-64, Available at SSRN: https://ssrn.com/abstract=2162658

Robert J. Rhee (Contact Author)

University of Florida Levin College of Law ( email )

P.O. Box 117625
Gainesville, FL 32611-7625
United States

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