How contractual agreement affects CRA incentives and rating biases

Abstract

This study investigates if a rating-contingent or performance-contingent contract can better discourage credit rating agencies (CRAs) from disclosing biased ratings, resulting in mitigation of the capital market liability of foreignness (CMLOF). The model considers the reputational loss from issuing uninformative ratings and CRAs’ unobservable conduct in inflating and deflating ratings. The exerted effort and rating disclosure policies decided by the CRA are unobservable publicly. Findings depict that the CRA under the rating-contingent contract may put no effort and inflate ratings in a favorable market while the performance-contingent contract provides stronger incentives for CRAs to exert optimal effort in generating informative ratings and disclosing them truthfully. By adopting this incentive-based contract, foreign firms can demonstrate a commitment to truthfulness and transparency, distancing themselves from the entrenched practices of credit rating production, which are under scrutiny. This alleviates CMLOF and enables foreign firms to compete effectively when entering international markets.

JEL classification: G24, G28, D82, D86