Competition in Certification Markets

This paper presents a theoretical model of competition between information intermediaries applied to credit rating industry. Sellers rely on intermediaries to credibly communicate their quality to buyers. Intermediaries are strategic and compete in fees as well as their certification standards i.e. how strict they are in awarding a certification. Choices of fees and certification standards induce a signaling game between buyers and sellers where through their choice of intermediary, sellers can convey information about their quality to buyers. In equilibrium, intermediaries set differentiated certification standards. The leader sets a high standard and the follower sets the minimum standard of certification. This serves to relax price competition and leads to a two-tier market structure where high (low) quality sellers opt for intermediary with high (low) quality standards. The differentiated certification standards result is also tested empirically for the credit rating agencies who certify commercial banks. The empirical results confirm that credit rating agencies use differentiated rating standards in this market