Intermediaries Revisited: Is Efficient Certification Consistent with Profit Maximization?

Abstract

Private certification mechanisms are a key component of the regulatory infrastructure in the financial sector and other commercial settings. It is generally assumed that certification intermediaries have profit-based incentives to deliver accurate information to the certified market. But this view does not account for repeated failures in certification markets. Those failures can be explained by an inherent defect in the incentive structure of certification intermediaries: entry barriers both support and undermine the consistent supply of accurate information to the certified market. Certification markets tend to converge on a handful of providers protected by switching costs, product opacity and reputational noise. Those entry barriers induce incumbents both to preserve reputational capital by making investments to maintain informational accuracy and to save costs by periodically reducing those investments. Regulatory interventions to improve certifier performance are prone to overestimate the market’s demand for certification accuracy or eliminate the “rent cushion” that supports certifiers’ incentives to invest in informational quality. In lieu of regulatory intervention, certification entities historically have adopted nonprofit, mutual and other “constrained” organizational forms, often embedded within higher-order certification and accreditation mechanisms, which reduce certifiers’ incentives and opportunities to shirk. These arguments are illustrated through case studies of certifiers’ organizational practices in the financial market, where certifiers have widely abandoned the long-standing use of constrained forms, and “ethical consumption” markets, where the most successful certifiers have widely adopted constrained forms.