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Performance-based payment scheme to hedge against credit rating inflation

Author

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  • Charoontham, Kittiphod
  • Amornpetchkul, Thunyarat (Bam)

Abstract

Credit rating inflation is a prevalent issue in financial markets. Existing studies have attributed a cause of inflated rating to credit rating agencies’ biased conduct for their own benefits. In this paper, we propose a performance-based payment mechanism which can be used to align the incentives between the issuers seeking ratings and the rating agencies. Under the proposed mechanism, the issuer who brings in a risky project for rating can specify the level of information to be obtained by the rating agency; whereas, the rating agency can choose whether to report the acquired information truthfully. After the rating has been announced and the investment decision has been made, the project return is shared between the issuer and the rating agency according to the predetermined terms. We show that as long as the issuer carries a sufficiently large portion of the project return, the credit rating agency will have no incentive to inflate ratings. As a result, the accuracy of the rating as well as the expected return from the project can be significantly improved.

Suggested Citation

  • Charoontham, Kittiphod & Amornpetchkul, Thunyarat (Bam), 2018. "Performance-based payment scheme to hedge against credit rating inflation," Research in International Business and Finance, Elsevier, vol. 44(C), pages 471-479.
    • Handle: RePEc:eee:riibaf:v:44:y:2018:i:c:p:471-479
    DOI: 10.1016/j.ribaf.2017.07.117
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    References listed on IDEAS

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    Cited by:

    1. Hoppe-Wewetzer, Heidrun C. & Siemering, Christian, 2020. "Advertisement-Financed Credit Ratings," CEPR Discussion Papers 14735, C.E.P.R. Discussion Papers.

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    More about this item

    Keywords

    Performance-based payment; Project evaluation; Credit rating agency; Rating inflation; Information accuracy;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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