Upfront versus rating contingent fees: Implications for rating quality

- I examine if an upfront fee improves the rating quality of a credit rating agency.
- Upfront fee does not improve quality if accuracy is set before rating is solicited.
- Upfront fee can improve quality if accuracy is set after a rating is solicited.
- Marketing the specifics of rating criteria ex ante should be prevented.

This paper theoretically investigates whether compensating a credit rating agency (CRA) with an upfront fee, rather than a rating contingent fee, can improve rating quality. I show that an upfront fee delivers the same rating quality as the rating contingent fee if the CRA sets its rating policy before the issuer solicits a rating, whereas it can potentially improve quality if the rating policy is set only after a rating is solicited. These results suggest that the “Franken Amendment” that has been removed from the Dodd-Frank Act might be crucial for the proposed upfront fee regime to improve rating quality.