Date Added: Nov 2010
The author demonstrates that the issuer-pay rating model adopted by major credit rating agencies contributes to their incentives to issue inflated ratings. Employing a unique dataset, the author compare credit ratings based on the issuer-pay rating model to those based on the investor-pay model. The author finds that when the expected compensation is high, the issuer-pay based rating agencies assign a more favorable rating to the issuer. Additionally, the author presents evidence that neither regulators nor investors seem to adjust for this rating bias. These findings raise questions about the effectiveness of credit ratings as a gauge of issuers' credit quality.