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Credit Rating Agencies: An Alternative Model

By Pragyan Deb and Gareth Murphy


We explore the conflict of interest which arises in the credit ratings industry due to the current issuer-pay model. We argue that the most efficient way of aligning the incentives of rating agencies is to return to an investor-pay system. Careful analysis of the reforms currently being discussed suggests that, by themselves, they will have insufficient impact if the current issuer-pay model is maintained. While a return to the pre-1970s investor-pay model would solve the conflict of interest problem, the issue of free-riding amongst some investors is likely to result in insufficient revenues for the rating agencies. We argue that although free-riding is a problem, the increasing use of ratings by institutions coupled with the rise in the speed of information diffusion and predominance of electronic trading venues over the last few decades would ensure that there are investors willing to subscribe to ratings. This investor-pay revenue could be supplemented by a government subsidy to ensure that sufficient resources are available to the rating agencies. To fund the government subsidy, we propose that a small tax would be levied on issuers or at the point of issue. A limited number of rating licenses which provided a ‘right to rate’ which would be auctioned (just like 3G auctions) and the auction winners would be entitled to a portion of the tax pool which is paid in arrears and linked to the share of the investor-pay market that they manage to achieve. Such a system would align the incentives of the rating agencies with investors, would ensure a commercially viable ratings agency industry and would have negligible impact on primary issuance markets

Topics: Competition, Reputation, Financial Regulation, Auction, Industrial Organisation JEL Classifications, C7, D4, G2, K2, L1, L9
Year: 2009
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