Credit rating agencies sometimes make egregious mistakes; because they are enormously influential, their mistakes can have calamitous consequences. Exhibit A is, of course, the misrating of subprime securities, a significant cause of the financial crisis from which we are still recovering.
In On Duopoly and Compensation Games in the Credit Rating Industry, Robert Rhee proposes a novel and ingenious solution to the credit rating agency problem. Rhee’s solution is to pay the rating agencies for good performance. The payments would come from the agencies with the vast bulk of the market: Moody’s, Standard and Poor’s (S&P’s), and Fitch, known as the “Big Three.” Five percent of their revenue would comprise a “bonus pool” to be paid to the best-performing agency of the three. If a smaller agency performs sufficiently well, Rhee’s solution would include a payment to them from this bonus pool.