Who Should Pay for Credit Ratings and How?

We analyze a model where investors use a credit rating to decide whether to finance a firm. The rating quality depends on unobservable effort exerted by a credit rating agency (CRA). We study optimal compensation schemes for the CRA when a planner, the firm, or investors order the rating. Rating errors are larger when the firm orders it than when investors do (and both produce larger errors than is socially optimal). Investors overuse ratings relative to the firm or planner. A trade-off in providing time-consistent incentives embedded in the optimal compensation structure makes the CRA slow to acknowledge mistakes. Received October 22, 2014; accepted August 29, 2015 by Editor Itay Goldstein.