Regulating Credit Rating Agencies

Abstract: The credit rating industry is characterized by a conflict of interest for credit rating agencies (CRAs). Although they should act as a neutral screening institution between issuers and investors, issuers of securities pay them. As a result, CRAs are incentivized to inflate ratings and issuers shop for favorable ratings. This thesis analyzes the two-sided credit rating market using an applied game theoretical framework, considering both payment streams and the concern CRAs have for their reputation. Furthermore, this thesis investigates the market outcome without any governmental intervention, as well as the simplification of the empirically observable inefficiency in the market (e.g., inflated credit ratings, rating shopping by issuers, inconsistencies in rating's quality over the economic cycle), then evaluates different regulation mechanisms. These mechanisms include those recommended by economic research (i.e., introducing an upfront fee for issuers and a mandatory rating publication), mechanisms implemented by the European Commission in 2013 (i.e., randomly allocating issuers to CRAs, increasing the accountability for CRAs, and less reliance on credit ratings), and regulations discussed in the media (i.e., a public certification institute as a reference CRA). The results show that a mandatory rating publication provides the greatest efficiency in the market, but is not feasible. The regulations implemented by the European Commission are promising and are shown to reduce failures in the credit rating industry. In contrast, a public certification institute does not significantly reduce the conflict of interest for CRAs because the institute is not able to act as a competitive actor in the market.