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Moral Hazard with Rating Agency: An Incentive Contract Approach

July, 2003

Bappaditya Mukhopadhyay
Management Development Institute, P.O.Box 60, Sukhrali, Gurgaon 122001, India bappa@mdi.ac.in

Abstract: In this paper, we address the issue of possible moral hazard that rating agencies might have. We discuss the feasibility of possible incentive contracts that can ameliorate this problem. We find, that incentive payments to the rating agency based on expected returns on debt will do away with the moral hazard problem. JEL Classification No. G140, G200, G290 Key Words: Credit Rating, Information Production, Moral Hazard.

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Introduction

Rating agencies are unique because, the users of their services do not pay directly for the information. Credit rating agencies evaluate and rate debt instruments. They publish ratings on the riskiness of such instruments. The firm, whose instruments are rated, pay for these services, while the ratings are available as public information, and hence, the users of these ratings, the investors, do not directly pay. Another, interesting fact associated with the ratings industry is that it is a regulated oligopolistic industry all over. In India, bulk of the ratings are done by the two leading rating agencies in India, CRISIL (Credit Rating Information Services of India Limited) and ICRA (Investment Information and Credit Rating Agency of India Limited). Often the arguments in favor of having such a few rating agencies are that, they promote ‘unhealthy competition’.1 These two facts lead to an obvious problem of moral hazard. In this paper, we discuss incentive contracts that will tackle such moral hazard issues. We model the credit rating agencies as information producing financial intermediaries. We consider a simple model where the economy consists of four risk neutral agents - an investor, a firm, a credit rating agency and the regulator (the government). The firm has a project with