In 2008, $14 trillion of highly rated bonds fell to junk status, resulting in the largest U.S. financial crisis since the Great Depression. Credit rating agencies (CRAs) have come under intense scrutiny as a result of this disaster, including congressional inquiries and government investigations. The authors provide an account of the ethics of the CRA industry.
Beginning with an overview of credit rating agencies (CRAs) as an integral part of the global financial system, the authors examine the history of CRAs, document their rise to importance, and review their role in the 2007–09 global financial crisis. They summarize the most common criticisms of CRA practices, the legislative responses to these criticisms, and the current policy proposals surrounding the issue of CRA regulation. They conclude with a discussion of the ethical considerations facing the CRA industry and how these challenges can be addressed in future reforms.
How Is This Research Useful to Practitioners?
Although much has been written about the CRA industry following the 2008 credit market collapse, the focus of this literature has been on financial system reforms necessary to avoid a repeat of the 2008 crisis. The authors focus more explicitly on the ethics of the CRA industry. They identify four common CRA industry criticisms: conflicts of interest stemming from the issuer-pay model, lack of transparency associated with proprietary assessment methodologies, insufficient competency needed to rate complex financial instruments, and lack of significant industry competition resulting from three agencies dominating 95% of the market.
The authors review recent legislation, including the 2006 Credit Agency Reform Act, the 2010 Dodd–Frank Act, and initiatives of non-U.S. regulators. They include a comparison of three competing policy perspectives: free market (deregulation), government regulation (increased regulation), and professional ethics (increased focus on codes of conduct and corporate responsibility).
The discussion of CRA ethics revolves around four concepts: ratings as a public good, mismatched expectations about the authority of a rating, nonwelfare considerations of equity and fairness, and the relevance of corporate responsibility for the CRA industry. Regulatory responses are examined using this ethical framework. Approaches favored by the authors include reducing the role of CRAs within financial markets, permitting investor lawsuits against CRAs, removing government endorsement of CRAs, removing requirements that certain entities use ratings to assess creditworthiness, and increasing emphasis on the public trust that CRAs must carry.
This article will be of interest to those seeking to learn more about the CRA industry and the ethical considerations facing these firms. In particular, CRA representatives, legislators, and regulators charged with fostering and enforcing fairness of the CRA industry; investors who rely on credit ratings to make investment decisions; and issuers that have their debt rated by these agencies will be interested in the authors’ work.
How Did the Authors Conduct This Research?
This article is qualitative in nature, and as such, the authors do not rely on datasets or quantitative testing in their research.
In providing an overview of the CRA industry and its history, they reference the existing body of academic research on the topic and rely on data from such sources as Bloomberg and Standard & Poor’s.
For regulatory perspective, the authors reference the 2006 Credit Agency Reform Act, the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act, Basel III, the Sarbanes–Oxley Act, the U.S. SEC, the International Organization of Securities Commissions, and the European Securities and Markets Authority.
Although some of the background information may be considered cursory by professionals with knowledge of CRAs, the authors provide a good overview of the CRA industry and the ethical considerations facing ratings companies. They identify a number of specific concerns regarding the CRA industry. Although they discuss how regulations address these issues, I would have liked to see more specific recommendations on actions that they believe would best alleviate their concerns. I would also be interested in seeing the authors conduct quantitative research that tests ratings effectiveness under various payment models.