Fear of Rejection? Tiered Certification and Transparency
Executive Summary — The sub-prime crisis has thrown a harsh spotlight on the practices of securities underwriters, which provided too many complex securities that proved to ultimately have little value. Certifiers such as rating agencies, journals, standard setting bodies, and providers of standardized tests play an increasingly important role in the market economies. Yet as scrutiny of rating agencies in the aftermath of the sub-prime crisis has shown, these organizations have complex incentive structures and may adopt problematic approaches. On an explicit level, all major rating agencies follow a well-defined process, whose end product is the publication of a rating based on an objective analysis. But firms have been historically able to get rating agencies not to disclose ratings that displease them. HBS professor Josh Lerner and colleagues examined when certifiers might adopt more complex rating schemes, rather than the simple pass-fail scheme, and highlight that such nuanced schemes are more likely when the costs of such ratings are lower. In addition, these schemes are more common when sellers are less averse to the revelation of information about their quality, and more impatient. Key concepts include:
- Absent regulation, certifiers have a strong incentive not to publicize rejected applications.
- Transparency regulation always benefits sellers, but need not benefit users.
The sub-prime crisis has shown a harsh spotlight on the practices of securities underwriters, which provided too many complex securities that proved to ultimately have little value. This uproar calls attention to the fact that the literature on intermediaries has carefully analyzed their incentives, but that we know little about the broader strategic dimensions of this market. The paper explores three related strategic dimensions of the certification market: the publicity given to applications, the coarseness of rating patterns and the sellers' dynamic certification strategies.
In the model, certifiers respond to the sellers' desire to get a chance to be highly rated and to limit the stigma from rejection. We find conditions under which sellers opt for an ambitious certification strategy, in which they apply to a demanding, but non-transparent certifier and lower their ambitions when rejected. We derive the comparative statics with respect to the sellers' initial reputation, the probability of fortuitous disclosure, the sellers' self-knowledge and impatience, and the concentration of the certification industry. We also analyze the possibility that certifiers opt for a quick turnaround time at the expense of a lower accuracy. Finally, we investigate the opportunity of regulating transparency.