If You Misrate, Then You Lose: Improving Credit Rating Accuracy through Incentive Compensation
Listokin, Yair, Taibleson, Benjamin, Yale Journal on Regulation
Credit rating agencies (CRAs) serve many roles in maintaining properly functioning debt markets. Their contribution to both Enron-era financial scandals and the 2008-2010 financial crisis, however, has led to many calls for credit rating reform. This Essay proposes an incentive compensation scheme in which CRAs are paid with the debt they rate. If a CRA overrates debt, then the CRA suffers a financial penalty because the debt the CRA receives as compensation is less valuable than the cash compensation that the debt is replacing. We believe that this reform, though imperfect, would be more likely to generate accurate ratings than other credit rating reform proposals. We also discuss extensions of our basic debt compensation proposal that mitigate some of debt compensation's weaknesses, though at the cost of greater complexity.
How does one estimate the probability that a loan will go into default? This question is critical in the face of the 2008-2010 financial crisis. The simplest answer may be to "leave it to the market," but there are several obstacles to this approach. To protect against financial instability, governments may provide some sort of guarantee to creditors of financial institutions. To ensure that financial institutions do not exploit this guarantee, regulators may require financial institutions to hold "safe" capital, which in turn requires some estimate of the default probabilities of securities held by financial institutions.1 Default probability estimates are also useful for preventing pension managers and other money managers from taking excessive risks. Finally, many credit securities have relatively illiquid markets, making market-oriented estimates of default probabilities imperfect. This problem grows especially acute in periods of market failure, such as the stoppage of markets for mortgage-backed securities and commercial paper in the fall of 2008.
Credit ratings exist to ameliorate many of these deficiencies. Credit rating agencies (CRAs), such as Standard & Poor's, Moody's, and Fitch, are paid by loan issuers to estimate the default probability of loans.2 Issuers pay for ratings, because a host of government regulations require investors to hold ratings above a certain threshold; without a rating, the pool of investors for the loan shrinks. By providing information to suppliers of capital, ratings also help mitigate asymmetric information problems that may undermine market functioning.3 This has created an enormous market for credit ratings. American CRAs rate over $30 trillion of debt,4 and Moody's has had the highest profit margin in the Standard & Poor's 500 for five consecutive years.5
Unfortunately, failures by the three primary bond raters have played a central role in the 2008-2010 financial crisis.6 The agencies gave high ratings to securities through a form of financial alchemy.7 These ratings facilitated the sale of the securities to institutions seeking relatively high yields from securities that met or exceeded their minimum rating qualifications, helping to fuel the housing and credit bubbles by increasing access to credit. Financial companies, the creators of the securities, held mortgages and other assets as inventory to form more securities. When the housing and leveraged buyout bubbles burst, the mortgages underlying the securities began to default, reducing the value of the highly-rated securities and of the inventory held by financial companies. These reductions in value, in turn, reduced the capital cushion of highlyleveraged financial companies, creating the conditions for the financial meltdown.8 Finally, a lack of confidence in the accuracy of ratings contributed to market failures fueled by information asymmetries. Without reliable ratings, complicated securities became untouchable at almost any price.9
Unlike many other organizations implicated in the financial crisis,10 Standard & Poor's, Moody's, and Fitch continue to exist and occupy the same role that they did before the crisis. …