Brief Analysis on Conflicts of Interest of Credit Rating Agencies

By Lu, Zhang; Yanyan, Xing | Canadian Social Science, July 1, 2012 | Go to article overview

Brief Analysis on Conflicts of Interest of Credit Rating Agencies


Lu, Zhang, Yanyan, Xing, Canadian Social Science


Abstract

With the outbreak of the current US financial crisis and European sovereign debt crisis, the current credit rating system has indicated various problems, and especially the conflicts of interest are becoming more and more obvious. Based on the issuer-pays mode, this article analyzes the causes of such conflicts of interest from the angle of regulation of fiduciaries, including international regulation, and puts forward suggestions on solution of such conflicts.

Key Words: Rating agency; Conflicts of interest; Fiduciary; Regulation

The role of credit rating agencies as "gate keeper" of the market has been challenged since the occurrence of the subprime mortgage crisis in 2008. Those agencies gave virtual high ratings on subprime mortgages and such structured financing products as CDOs, which accelerated the burst of subprime mortgage bubble and the crisis. After the outbreak of the crisis, those irresponsible agencies considerably lowered the ratings of such kinds of products, which resulted in market panic and increasing market fluctuations, which in turn led to the formation of the "procyclical effect" of financial crisis, and spread of the subprime crisis (Krugman, 2010). Why did the function of rating agencies as the "gate keeper" of market fail to work? Though we may not attribute all liabilities for this crisis to those agencies, what was shown in the crisis, for example, moral hazard and conflicts of interest, does disable such agencies to keep their objectivity and independence. Especially, the conflicts of interest are the main cause for loss by rating agencies of their independence.

1. EVOLVEMENT OF CONFLICTS OF INTEREST1 OF CREDIT RATING AGENCIES

The credit rating industry emerged after Moody's conducted the primary credit rating on railway bonds in 1909. At the beginning, credit rating was for free, which lasted until the year of 1968 when the top three credit rating agencies collected charges from investors for the information related to credit ratings they provided. At that time, thanks to single kind of clients and financial products of credit rating agencies, there were almost no conflicts of interest. However, such charging mode easily generated "free-riders" and moral hazards. Moody's and Fitch Ratings started to collect charges from issuers after 1968; in other words, securities issuers should pay credit rating agencies for credit ratings on their securities. Currently, the charges paid by issuers account for most part of the revenues of main credit rating agencies. The documents of SEC 's hearing on November 21, 2002 indicated that 90 percent of the revenues of Moody's was from credit rating charges paid by issuers and the remaining 10 percent from research and data service it provided; similarly, among the revenues of Fitch Ratings, 90 percent came from issuers and about 10 percent from payment by investors. (YING & ZHANG, 2006) In such issuer-pays mode, credit rating agencies play two roles as the "issuers' seller" and the "investors' agent" at the same time, who collect charges from the entities to be rated while disclosing securities risks to investors. In such way, the original principal-agent relationship is distorted and the potential of conflicts of interest rises.

Since credit rating on bonds relates to issuers, investors and regulators, who may have different interests, and credit rating agencies also play different roles, when their interests are inconsistent in certain situations, conflicts of interest may be inevitable. (NIE, 2011) The working mechanism of conflicts of interest in the issuer-pays mode is as follows:

A credit rating agency collects data and information for detailed investigation and analysis on an entity to be rated; - ? the credit rating agency determines the credit rating of the entity; - ? the credit rating agency releases the credit rating on the entity to investors; - > investors decide whether to invest the entity based on the credit rating at their own discretion and regulators supervise the entity based on the credit rating; - > the investment of investors impacts the financing scale and cost of the entity; - > the credit rating agency receives credit rating charges from the rated entity (as well as the fees paid by some investors for journals published and provided by the credit rating agency). …

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