We study competition between an incumbent Credit Rating Agency (CRA) and a sequence of entrant CRAs that are potentially more effective but whose ability in appraising default risk is unproven when they enter the market. We show that free entry competition fails to select 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. Second, CRAs cannot charge higher fees for low rating than for high rating. Then, a rather incompetent CRA can dominate the market without concerns about entry. We derive policy implications.
- D82: Asymmetric and Private Information • Mechanism Design
- G29: Other
- L11: Production, Pricing, and Market Structure • Size Distribution of Firms
- L13: Oligopoly and Other Imperfect Markets
- L15: Information and Product Quality • Standardization and Compatibility
TSE Working Paper, n. 11-235, May 10, 2011, revised May 25, 2012