“Can skin-in-the-game discipline credit rating agencies?” by Dion Bongaerts
RSM Erasmus University
This paper investigates whether and how skin-in-the-game based mechanisms can increase credit ratings accuracy and hence social welfare. I use a theoretical model with rational investors and issuers that prefer high over accurate ratings. In line with recent patterns, my basic model generates slacking credit rating agencies (CRAs), negative social welfare, limited regulatory power and high sensitivity to bubbles and bursts. Requiring sufficiently large co-investments upon issuing high ratings generates first-best outcomes with a monopolistic CRA, but can produce captive equilibria when CRAs compete. In addition, co-investments reduce fragility of equilibria, making bubbles and bursts less likely. Alternatively, the threat of competition from co-investing and rating-producing banks can also induce higher effort from CRAs by making the regulatory threat to revoke CRA licenses more credible.