Credit Assessment and Consulting in Credit-Rating Agencies

Investors use credit ratings (e.g., Aaa or Baa) that reflect the probability of default to determine the creditworthiness of particular debt securities. As a consequence, debt ratings play a major role in the pricing of debt securities and in the regulatory process. Conflicts of interest can arise when multiple users with divergent interests (at least in the short term) depend on the credit ratings. Investors and regulators are seeking a well-researched, impartial assessment of credit quality; the issuer needs a favorable rating. In the credit-rating industry, the issuers of securities pay a rating firm such as Standard and Poor's or Moody's to have their securities rated (see the FYI box). Because the issuers are the parties paying the credit-rating agency, investors and regulators worry that the agency may bias its ratings upward to attract more business from the issuer.

Other conflicts of interest may arise when credit-rating agencies also provide ancillary consulting services. Debt issuers often ask rating agencies to advise them on how to structure their debt issues, usually with the goal of securing a favorable rating. In this situation, the credit-rating agencies would be auditing their own work and would experience a conflict of interest similar to the one found in accounting firms that provide both auditing and consulting services. Furthermore, credit-rating agencies may deliver

FYI. Why Do Issuers of Securities Pay to Have Their Securities Rated?

Prior to the 1970s, credit-rating agencies earned revenues by having subscribers pay to receive information about securities ratings. In the early 1970s, however, the major rating agencies switched to having issuers of securities pay for their ratings. Why would they do this, given that it appears to set up an obvious conflict of interest?

The answer is provided by the asymmetric information framework, which was discussed in Chapter 8. By the early 1970s, technological changes, such as the advent of cheap photocopying, made it easier to disseminate information. Market participants were able to readily get information on securities ratings without paying for it. The free-rider problem became more widespread. As a result, the credit-rating agencies were no longer able to earn enough revenues by selling ratings information. The solution was to have the issuers of securities pay for the ratings, and this is the business model that we see currently.

favorable ratings to garner new clients for the ancillary consulting business. The possible decline in the quality of credit assessments issued by rating agencies could increase asymmetric information in financial markets, thereby diminishing their ability to allocate credit.

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