Tuesday, August 2, 2011
Posted by D. Daniel Sokol
Doh-Shin Jeon (Toulouse School of Economics) and Stefano Lovo (HEC) examine Natural Barrier to Entry in the Credit Rating Industry.
ABSTRACT: We present an infinite horizon model that studies the competition between a relatively ineffective incumbent Credit Rating Agency (CRA) and a sequence of entrant CRAs that are potentially more e¤ective but whose ability in appraising default risk is unproven at the time they enter the market. We show that free entry competition in the credit rating business fails in selecting the most competent CRA as long as two conditions are met. First, investors and issuers trust the incumbent CRA to provide a sincere, although imperfect, assessment of issuersdefault risk. Second, CRAs cannot charge higher fees for low rating than for high rating. Under these conditions a rather incompetent CRA can dominate the market without being worried about potentially more competent entrants. We derive policy implications.