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‘Issuer Pays’ Model Vs. ‘Investor Pays’ Model

‘Issuer Pays’ Model Vs. ‘Investor Pays’ Model

By Ravi Kant

Edited by Liz Maria Kuriakose, Associate Editor, The Indian Economist

Since the evolution of the Credit Rating Agencies (CRAs), all of these CRAs (S&P, Moody’s, Fitch) followed ‘Investor-pays’ model till 1970s. Investors subscribed to the ratings released by the CRAs, and this subscription was the main source of revenue for the rating agencies. After the Penn-Central Rail Road Crisis and the fear of piracy of rating manuals issued by these CRAs (because of photocopy technology being famous), these CRAs changed their business model from ‘Investor-Pays’ to ‘Issuer-Pays’. The purpose of this discussion is to know whether these rating agencies should change their business model or not, or should they stick to the present models for doing their business.

With the Subprime Crisis, many believe that the present model (Issuer pays) has a lot of conflicts of interests. Many companies and banks have tie-ups and contractual agreements with CRISIL, ICRA, etc. Now this form of business invites huge criticisms and gives an opportunity for people outside to criticize these rating agencies. Deb and Murphy (2009) says that such kind of tie-ups and contractual agreements will lead to negotiated and inflated Corporate ratings whereas Kashyap & Natalia (2013) are of the view that the issuer-pays model renders less accurate ratings than the Investor-pays model. In-fact the ‘Issuer-Pays’ Model leads to ‘Rating Shopping’ which refers to the situations where an issuer approaches different rating agencies for preliminary ratings and then choose to publish the most favorable ratings to disclose it to the public via media while concealing the lower ratings. This ‘Rating Shopping’ compels the rating agencies to compromise on the quality of the credit ratings. This brings us to another proposition that the increasing competition in the rating industry will affect the quality of ratings via Rating Shopping. Skreta and Veldamp (2009) argues that the asset-class which is more simple in nature, the agencies ’ratings are similar and the incentive to ratings shop is low and when the assets are complex, ratings differ and an incentive to shop increases. They also believe that if the issuer of the asset discloses only the most favorable rating, then increasing the number of rating agencies will (weakly) increase the bias of the disclosed rating. Alan Greenspan acknowledged the greater complexity of CDOs in his May 2005 testimony, “The credit risk profile of CDO (Collateralized Debt Obligations) tranches poses challenges to even the most sophisticated market participants.” He cautioned investors “not to rely solely on rating-agency assessments of credit risk.” If we talk about the ‘Investor-Pays’ Model, most of the research papers are also of the view and that the investor-pay model is the most effective way of aligning incentives of rating agencies and investors by eliminating the conflict of interest of rating agencies. This model of business checks the bias in the ratings. It bans Rating Shopping since rating agencies would themselves have a strong incentive to comply with it. However ‘Investor-Pays’ Model also possess some problems. The biggest problem of this model is ‘free-riding’ which decreases the revenue of the rating agencies. Also ratings would then be available only to those investors who can pay for them and takes ratings out of the public domain. Smaller investors would stand to lose out the most, since they cannot afford to commission a ratings exercise. And this type of Model will only be possible if there is close to NO Competition in this Industry. The ‘investor-pays’ model also creates a deep-rooted bias towards credit rating agencies giving lower-than-warranted ratings, so that investors would get a higher yield. And pressures from investors to avoid rating downgrades would increase considerably, since downgrades result in market-to-market losses on rated securities.

If we come back to ‘Issuer-Pays’ Model, this model also has its own disadvantages and benefits. The biggest advantage of this model is that the ratings are available to the entire market. The information available to all the investors would be free of charge and will highly aid the small investors. While the ‘Investor Pays’ Model will have to rely on the information available on the public domain, the ‘Issuer Pays’ Model will not only have public information but will also have access to confidential and quality information about the issuer for the ratings.  An investor can compare the ratings of a wide array of instruments before making an investment decision, and can continuously evaluate the relative creditworthiness of a wide range of issuers and borrowers. Moreover SEBI has already issued a guideline to stop ‘rating shopping’ by asking the rating agencies to disseminate all the ratings issued by it, regardless of their acceptance or rejection by their clients.

Every Model has its own pros and cons. So the robustness of the model depends on how well these two objectives are achieved by the rating agencies – One, ensuring high-quality and accurate ratings, and two, widespread availability of ratings to all the market participants. I believe ‘Issuer Pays’ Model is better as this business model has less severe disadvantages as compared to the other alternative. On May 2010, SEBI issued guidelines for Credit Rating Agencies in India that for avoiding potential conflict of interest, a rating agency will have to ensure that the analysts of the CRAs do not participate in any kind of marketing and business development, including negotiations of fees with the issuer whose securities are being rated. Also, the employees involved in the credit rating process and their dependants cannot own shares of the issuer. Hence the new guidelines make the present business model. One example of a rating agency that operates today on the basis of ‘Investor-Pays’ Model is Egan-Jones Ratings which is now recognized by the US SEC, but its coverage and impact is low. To restrict Rating Shopping, the present business model requires strong barriers to the entry and less competition and therefore Credit Rating Industry especially in India should continue as an oligopolistic market or move towards the monopoly market. To sum up, ‘Issuer-Pays’ Model is more robust in nature, if it is complemented with a strict regulatory framework.


Ravi Kant has pursued Economics Honors from Ramjas College, University of Delhi. He loves watching Art Cinemas of bollywood and research in the area of Economics, English Literature, Strategy and history. He wants to be an eminent Consultant in the area of Economics and Strategy. Presently he is doing his MBA in Finance from Institute of Management Technology (IMT), Hyderabad.

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