The Existing and Proposed Credit Rating Agency (CRA) Business Models and Compensation Models Are Inefficient

Credit ratings agencies (CRAs) are prone to various antitrust and conflict-of-interest problems that arise from their regulation and their business and compensation models. CRAs have played a critical role in global capital markets for the last few decades, and the inefficiencies inherent in the compensation contracts, and business models of CRAs were clearly illustrated during the Global Financial Crisis of 2007-2011, during which ABS trusts and some large companies suddenly defaulted without prior downgrades of their ratings – it's well known that markets often price in potential defaults or down-grades before CRAs revise their ratings downwards. This chapter explores the inefficiencies of the existing and proposed CRA business models and compensation models.

Enforcement Theory, ESG, and Geopolitical Issues

The objective of this chapter is to review some of the complex systems and institutional factors that can influence the evolution of professional services companies (accounting/auditing firms, CRAs, and management consulting firms), compliance (as a physical phenomenon), enforcement, allocation of resources, risk perceptions, and sustainable growth (within the context of investors' decisions, sustainable growth, and geopolitical factors).

Models of Willingness-to-Comply

Sarbanes Oxley Act (“SOX”; USA), the PCAOB, and the Dodd Frank Act (USA statute) and similar institutions in other countries have become major macroeconomic, sustainability, and IPE (international political economy) policies because of their significant domestic and cross-border multiplier effects across countries and industries via US multinational corporations (MNCs) and foreign companies that do business in the US and or list their shares/debts on US financial exchanges. SOX, the PCAOB and the Dodd Frank Act have had pervasive effects on accounting firms, consulting firms, and credit rating agencies (CRAs) in the US (e.g., disclosures, professional standards, regulation/compliance, standard-of-care, legal liability, internal controls, daily operations processes, etc.), but SOX, the Dodd Frank Act, and the PCAOB have failed.

Complex Systems, Competition/Antitrust, and Legal Problems in the Global Credit Rating Agency Industry

This chapter explains how the tie-breaker effect reduces social welfare and distorts equilibria. This chapter introduces new definitions of “equilibrium” in the CRA ratings processes. (This has been one of the major missing elements in the existing literature on the credit ratings industry) It explains why “reputational capital” (of CRAs) is a sub-set of “influence” (which can have more impact on bond-issuers' decisions and investors' decisions than traditional “influence”) and critiques the games theorems in Virag and other important papers.

Financial Stability, Sustainable Growth, and the Global Quasi-Franchising/Business-Opportunity Industry

Franchising, Quasi-Franchising and Business-Opportunities have become major business models (particularly in the retailing and hospitality industries), and have substantial effects on company strategy, growth and survival Business Opportunities (regulated in some developed countries) and Quasi-Franchising (often un-regulated in many countries) are milder types of Franchising. There are at least 1,500 operating franchising networks in the U.S. that represent more than 760,000 franchisees and more than 18 million employees, and provide more than US$506 billion of payroll (or about 11% of the U.S. private sector payroll) and generating a total annual economic output that exceeds US$1.5 trillion (about ten percent of the U.S. private-sector economy). This chapter: i) critiques existing theoretical and empirical studies on franchise contracts, Business Opportunity contracts and incentives; ii) critiques the use of game theory in franchising studies; iii) introduces new mathematical models of Business Opportunities and Quasi-Franchising; iv) compares Business Opportunities, Franchising and Quasi Franchising.

Structural Change and Antitrust in the Global Auditing/Consulting Industry and Associated Environmental-Pollution/Climate-Change Issues

During 1990-2020, the global auditing/accounting and management consulting industry sectors experienced significant structural changes which have had un-even effects among large, medium and small auditing firms. The first section of this chapter summarizes the structural changes. The second section summarizes the antitrust problems. The third section discusses some of the climate-change and environmental pollution problems that are significantly affected by regulation of accounting firms and consulting firms; and introduces new solutions. In many countries, accounting firms have the primary responsibility for auditing firms' compliance with mechanisms such as emissions credits, environmental/sustainability accounting and compliance with environmental regulations; and consulting firms (by advising boards-of-directors and senior executives) informally and substantially influence firms' policies and procedures pertaining to waste/pollution and climate-change. The topics of the three sections (structural change, antitrust and the auditing/consulting firms' role in external audits and strategy pertaining to pollution, climate change and waste-management) are linked and or can have symbiotic effects on each other.

A Comparison of CRAs (Credit Rating Agencies), Management Consulting Firms, Environmental Auditing Firms, Tax Consulting Firms, and Auditing/Accounting Firms

This chapter compares CRAs (credit rating agencies), management consulting firms, environmental auditing firms, tax consulting firms, and auditing/accounting firms with the purpose of providing a better understanding of the current and possible regulatory, mechanism design, and industrial organization factors that can affect the global accounting/auditing industry and the global CRA industry. It also analyzes banks, credit rating agencies (CRAs), and investors as joint tortfeasors and co-conspirators (in litigation against accounting/auditing firms).

Informal Algorithms, Impossibility Theorems, and New “Learning” Business/Compensation Models for the Credit Rating Agency Industry

This chapter adopts agent-based and complexity approaches and introduces new “learning business models” and compensation contracts for CRAs that can solve the conflicts of interest, antitrust, greed, regret, deadweight-losses, complexity, and industrial organization problems inherent in the credit rating agency industry, and each model contravenes Myerson-Satterthwaite impossibility theorem, Arrow's impossibility theorem, Sen's impossibility theorem, Gibbard's theorem, the Gibbard-Satterthwaite impossibility theorem, and the Green-Laffont impossibility theorem. The business models include “quasi multi-sided auctions” wherein at any time t several auctions can simultaneously occur, and the payoff functions of any buyer-seller pair in any auction depends on the bidding done by at least another buyer-seller pair either at the same time, or at a different time. This “long-memory bias” of buyers and sellers in auctions is new in the literature.

On Impossibility Theorems, Informal Algorithms, and International Trade

The “Big-Four” accounting firms dominate the global accounting/auditing industry, and the big-seven consulting firms (Bain; McKinsey; Booz; Deloitte; PwC; KPMG and E&Y) dominate the global business/management consulting industry and stifle competition. During 1990-2017, the global auditing/accounting industry and the global management consulting industry experienced significant structural changes that have implications for Financial Stability, systemic risk and the proper functioning of capital markets. Some of the results included the collapses of stock prices and bond prices of firms suspected of earnings management; and substantial litigation against auditing firms, CRAs and board of directors. Accounting/audit firms and consulting firms have always been key elements in the fight against earnings management, securities fraud, corruption and asset quality management because of their unique position as external auditors and advisors. This chapter introduces some efficient Auditor allocation and Compensation Mechanisms. These new “Learning Business Models” and contracts can solve the conflicts of interest, Antitrust, greed, Regret, Deadweight-Losses, complexity and industrial organization problems inherent in the Auditing/consulting industry; and each such model contravenes Myerson-Satterthwaite Impossibility Theorem, Arrow's Impossibility Theorem, Sen's Impossibility Theorem, Gibbard's Theorem, the Gibbard-Satterthwaite Impossibility Theorem, and the Green-Laffont Impossibility Theorem. These issues have implications for international trade and international capital flows given the prevalence of accounting and management consulting in almost all aspects of modern business.