Credit Ratings Accuracy and Analyst Incentives

The financial crisis has brought a new focus on the accuracy of credit rating agencies (CRAs). In this paper, we highlight the incentives of analysts at the CRAs to provide accurate ratings. We construct a model in which analysts initially work at a CRA and can then either remain or move to a bank. The CRA uses incentive contracts to motivate analysts, but does not capture the benefits if the analyst moves. We find that rating agency accuracy increases with CRA monitoring, bank profitability (a positive "revolving door" effect), and can be non-monotonic in the probability of an analyst leaving. The recent financial crisis has prompted an investigation into the business of credit rating agencies (CRAs). With the rise of structured finance products, the agencies rapidly expanded their ratings business. This expansion seems to have come at the expense of ratings accuracy, as the CRAs increasingly gave top ratings to structured finance products shortly before they collapsed (Adam Ashcraft, Paul Goldsmith-Pinkham, and James Vickery, 2010). The academic literature has focused, unsurprisingly, on the reasons that ratings quality suffered, pointing to the lack of sophistication of investors (e.g. Vasiliki Skreta and Laura Veldkamp, 2009), the conflicts of interests that CRAs face (Patrick Bolton, Xavier Freixas and Joel Shapiro, 2010), and regulatory arbitrage (Lawrence J. White, 2010). In this paper, we focus on a different channel for fluctuations in CRA accuracy: the labor market for ratings analysts and their incentives to provide accurate ratings. ∗Bar-Isaac: Economics Department, Stern School of Business, NYU, Suite 7-73, 44 West 4th Street, New York, NY 10012, [email protected]. Shapiro: Said Business School, Oxford University, Park End Street, Oxford OX1 1HP UK, [email protected]. Acknowledgements: We thank Vicente Cuñat, Marco Pagano and Larry White for comments and productive discussions.