Natural Barrier to Entry in Credit Rating Industry

Abstract

In this paper, we examine whether there is a natural barrier to entry in the credit rating industry. We consider an infinite horizon model in which each period, an original incumbent faces competition from an entrant randomly selected from a pool of ex ante identical potential entrants. The incumbent's accuracy is constant, known and imperfect while each entrant's true accuracy is unknown and can be perfect or completely noisy. We study whether the market provides a right incentive to experiment entrants. In the benchmark in which the signal that a CRA receives is public information, we find that the market provides either a right or a socially excessive incentive. On the contrary, when the signal is private information, the experimentation never occurs and the incumbent always dominates the market. Our results suggest that a rather incompetent CRA can dominate the market without being worried about entry of potentially more competent entrants. We also derive policy implications.