- 22 Jul 2009
- Working Paper Summaries
Reputation and Competition: Evidence from the Credit Rating Industry
Overview — Credit ratings are a key aspect of the financial system. The quality of these ratings is certainly sustained in part by the reputational concerns of rating agencies, whose paying customers have no inherent interest in the quality of ratings. Competition in this industry has been increasing, and there have been calls for yet more competition. Whether competition will reduce quality or improve it is not yet clear. HBS professor Bo Becker and Washington University in St. Louis professor Todd Milbourn test these conflicting predictions in the ratings industry. Their evidence is more or less consistent with a reduction in credit rating quality as Fitch increased its market presence. Their empirical findings suggest that the system will work better when competition is not too severe. These results have potential policy implications. Key concepts include:
- Competition is associated with "friendlier" ratings.
- For regulators, it is worth considering that increasing competition in the ratings industry involves the risk of impairing the reputational mechanism that underlies the provision of good quality ratings.
- For bond markets, it is clear that relying on third party ratings paid for by issuers is not a system without risks.
Fair and accurate credit ratings play an important role in the financial system, but investors and regulators who use ratings cannot easily verify their quality and ratings are paid for by the firms whose bonds are rated. The provision of quality ratings is at least partially sustained by the reputational concerns of the rating agencies. We use the rise of a third ratings agency to examine competition and reputation. Consistent with Klein and Leffler (1981), competition leads to lower quality in the ratings market: the incumbent agencies produce more issuer-friendly and less informative ratings when competition is stronger.