Focus on Research

February 25, 2013 11:43 am

Rating agencies compromised by payment model

Recently published research by two professors at Bentley University in Massachusetts, argues that credit agencies’ objectivity in their evaluation of risk in capital markets has been compromised by “tacit collusion” with the very companies that they assess.

Analysis by Cynthia Clark and Sue Newell of the three leading agencies, Fitch, Moody’s and Standard and Poor’s, concludes that “raters have overly relied on the information coming from the organisations being rated, rather than trying to analyse this information independently.”

They argue that as agencies “de-coupled” from their mandate of independent analysis, “ratings underestimated the complexity and performance of bonds and mortgage-backed securities”. Downgrades of mortgage-backed securities by the agencies in 2007 provided a “public admission that they all had underestimated the risk”, they write in Business Ethics Quarterly.

At the heart of the process of “complicit de-coupling”, as the professors call it, is an inherent conflict of interest in the agencies’ payment model, whereby rated companies directly pay for their own ratings, they write. Companies are reported to have routinely shopped around for the most favourable rating, the professors report. “Good ratings benefit the raters, who thereby get more business [and] the firms being rated, who can then attract more investors.”

The professors assert that this model has conspired to provide both credit rating agencies and their client-subjects with the shared incentive to uphold “the legitimacy facade that ratings continued to reflect accurately the underlying risk and worth of a security in the capital markets”. It remains in both parties’ interests therefore to “maintain this illusion” that high ratings reflected investments that had little risk of default, they argue.

Despite attempts since the market crash to address this conflict of interest, the issuer-payer model remains intact. Profs Clark and Newell conclude that “exposure [of the problem] does not undermine the legitimacy of the practice” because of the aligned interests of ratings agencies, rated firms and government, the latter of which “can point to the workings of oversight”.

Their research recommends that “wholesale changes are needed if the existing conflicts and the associated biased information are to be fully repaired” and argue that the agencies should charge investors who use their ratings, rather than the companies. If agencies continue to receive payment by rated firms, this conflict of interest should be clearly disclosed to investors, they add.

www.bentley.edu

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