Do the Credit Rating Agencies Deserve to Exist?

The International Economy, Fall 2008 | Go to article overview

Do the Credit Rating Agencies Deserve to Exist?


The proverb says it's no use locking the barn door after the horse is gone. But even if the door to the credit rating agencies can't be closed, should these institutions be disenfranchised, as many critics argue?

Do the rating agencies elevate or add to risk? Is the charge credible that these institutions have never been ahead of the curve in predicting the bursting of an economic or financial bubble? Should the U.S. Securities and Exchange Commission and similar international agencies disassociate from the agencies in the evaluation of risk?

Or are effective reforms possible?

Fourteen distinguished experts rate the raters.

[ILLUSTRATION OMITTED]

Yes, but eliminate their conflicts and have them report to the SEC.

MAURICE R. GREENBERG

Chairman and CEO, C. V. Starr and Company

The rating agencies are an integral component of the financial market. Done properly, their evaluations of credit risk are essential to many market participants who lack the resources or skill to make an independent evaluation.

The problem lies in the method whereby rating agencies are paid for their services which has changed adversely over the years. Once rating services sold their ratings to the purchasers of securities and were viewed as independent evaluators of risk. As securities became more complex, investment banks wanted to know in advance what would be the rating of the security before bringing it to the market. The rating agencies became engaged in the structuring of the securities and demanded to be paid for their efforts.

Investment banks soon learned to play one rating agency against another and only pay for the highest two ratings they would receive. The rating agencies, in order to maximize their own income, became co-originators of securities rather than the independent arbiter that was their original role. The rating agencies became reluctant to downgrade securities they helped to create. If institutions want or need the ratings supplied by the rating agencies, then they should pay for them.

The rating agencies must at all times be independent of the investment banks and originators of securities. If they are publicly owned, individual corporate investors should be limited to 5 percent of the outstanding common stock to avoid an appearance of conflict of interest.

In light of the important role they play in the functioning of the securities market, all of the ratings agencies should be subject to a self-regulatory body which would ultimately report to the Securities and Exchange Commission as do the self-regulatory bodies for the securities markets.

[ILLUSTRATION OMITTED]

They should be taken over by a public regulatory agency.

HEINER FLASSBECK

Director, Division on Globalization and Development

Strategies, UNCTAD, Geneva

Credit rating agencies should solve information problems and increase transparency. Indeed, they have played the opposite role and made the market even more opaque. As in all former crises, agencies were too optimistic. This is the systemic problem.

Rating agencies normally respond that their ratings include disclaimers that clarify that they are paid by the companies they rate and that ratings are only opinions and not accurate predictions of the risk of a given instrument. The problem is that rating agencies play an ambiguous role in the current regulatory environment as it renders rating decisions important in establishing what assets can be held by certain types of financial intermediaries.

A fundamental reform of crediting rating agencies and of their role in rating complex financial instruments is an indispensable step towards increasing transparency of the whole financial system. There is no private solution to this matter any more. What is needed is the establishment of a public regulatory agency which takes over the role of credit rating agencies.

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Do the Credit Rating Agencies Deserve to Exist?
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