Credit rating accuracy and incentives

Robert Jarrow, Liheng Xu

Abstract

ABSTRACT

Credit agencies rate the quality of risky debt issued by firms, who themselves pay for these ratings. This payment structure creates an incentive problem with respect to rating accuracy. This paper constructs an equilibrium model for studying the efficiency of this payment scheme and its accuracy. We show that this payment scheme increases welfare for the firm's shareholders but generates inaccurate ratings that accentuate the credit risk business cycle. As the number of rated debt issues grows, however, the payment scheme inefficiency goes to zero and the ratings inaccuracy disappears.