Rating disclosure analysis: compensation reform consequence on counteracting biased credit ratings

This study analyzes a compensation reform proposal designed to prevent inaccurate ratings produced by credit rating agencies (CRAs). Specifically, the CRA’s incentive to exert effort to observe the portfolio’s signal and adopt the rating disclosure policy is investigated under the rating-contingent and incentive-based contract. The issuer has a risky portfolio and solicits a rating from the CRA, which endogenously observes a signal and decides on a rating disclosure policy during the rating production process. The findings reveal that the CRA exerts no effort to observe a signal and inflate the rating under the rating contingent contract. Under the incentive-based contract, the CRA always exerts an optimal effort to observe a signal and adopt the full disclosure regime. Hence, the incentive-based contract better incentivizes the CRA to exert more effort to improve rating accuracy and implement the full disclosure policy than the rating contingent contract.