On Duopoly and Compensation Games in the Credit Rating Industry

Credit rating agencies are important institutions of the global capital markets. If they had performed properly, the financial crisis of 2008–2009 would not have occurred, and the course of world history would have been different. There is a near universal consensus that reform is needed, but none as to the best approach. The problem has not been solved. This Article offers the simplest fix proposed thus far, and it is contrarian. This Article accepts the central role of rating agencies in the regulation of bond investments, the realities of a duopoly, and the issuerpay model of compensation. The status quo is the baseline. While not ideal, this much-maligned state is still well suited for robust competition leading to more accurate credit ratings. The role of regulation should be to create the conditions necessary to induce competition. This Article proposes that a small, recurring portion of revenue earned by the largest rating agencies should be ceded to fund a pay-for-performance bonus, and that the agencies should compete for this bonus on a periodic winner-take-all basis. This modest, at-the-margin bonding mechanism would significantly affect incentives and outcomes: conflict of interest and implicit coordination would be minimized; competition would increase; the quality of ratings would improve. Furthermore, this funding scheme can promote the incubation of smaller new competitors through a program of “shadow competition,” creating a competitive information market on credit ratings. Since regulation would only be required to assess performance and would not change the fundamental industrial organization, this proposal has the advantage of simplicity and feasibility. AUTHOR—John H. & Mary Lou Dasburg Professor of Law (designate), University of Florida Levin College of Law; Professor of Law, University of Maryland Francis King Carey School of Law; Professor, Johns Hopkins Carey Business School; Visiting Professor, Georgetown University Law Center. This Article was presented at the 2012 conferences of the Law & Society Association, Midwest Law & Economics Association, and the Italian Society of Law & Economics, and at the University of Minnesota Law School. I thank Mark Graber, Michelle Harner, Claire Hill, Donald Langevoort, Brett McDonnell, Barak Orbach, Brian Quinn, Simone Sepe, Jana Singer, Daniel Sokol, and Max Stearns for their helpful comments. N O R T H W E S T E R N U N I V E R S I T Y L A W R E V I E W 86 INTRODUCTION 86 I. HISTORICAL BACKGROUND AND REVIEW OF PRIOR PROPOSALS 91 A. The Bond Market and the Credit Rating Industry 91 B. Poor Performance and Its Causes 93 C. Regulatory Responses 99 D. Review of Prior Proposals 102 II. PROPOSAL FOR A COMPENSATION COMPETITION 113 A. Properly Conceptualizing Competition and Incentive 113 B. Mandating Pay-for-Performance 114 C. Financial and Economic Analyses 118 D. Toward a Robust Secondary Market 124 III. POTENTIAL OBSTACLES TO IMPLEMENTATION 126 A. Coordination and Collusion 126 B. Standard for Performance Assessments 127 C. Regulatory Foundation Laid by Dodd–Frank 132 D. Political Reality of Regulation 134 CONCLUSION 136