In the recent debate about the role of rating agencies in the subprime debacle, conflicts of interest have received much attention. If rating agencies were not rating the financial products they helped construct, they would provide accurate information to market participants in order to safeguard their reputation, thus ensuring reliable ratings, or so the argument goes. But is it really the case that reputational concerns lead to reliable ratings?
In a recent paper, I argue that this is not the case: worrying about reputation is not the same as worrying about providing reliable ratings.
A rating agency assigns a rating based on information that is publicly available to all market participants and information that is privately assembled by its analysts or provided by the firm. This information goes through the rating agency’s credit model to produce a rating. If privately available information is inaccurate or difficult to interpret, or if the credit model is flawed, this may prompt a rating agency to make mistakes and issue an incorrect rating.1 When a rating agency that is aware of the imperfections in its ratings process finds itself in a situation in which a strongly held public opinion and its interpretation of its private information diverge, a rating agency might just conform to public opinion, issuing the rating that everyone expects, because of fears of being wrong.
Even when public opinion does not come down strongly on the side of either a good or bad rating, reputational concerns do not necessarily lead to reliable ratings. It is likely that market participants are more likely to find out about a mistake when a rating agency gives a good rating than when it gives a bad one - good ratings entail more investor interest and analyst coverage, and a wider range of investors will end up holding the securities of the rated firm. In a situation in which a rating agency faces no competition, it might want to be conservative, issuing bad ratings too often, ignoring both publicly and privately available information that indicate otherwise, as this behaviour minimises the chances of being identifiably wrong. In a situation in which a rating agency faces tough competition, it might prefer to be bold and issue good ratings too often, ignoring both publicly and privately available information that indicate otherwise, in order to gamble on increasing its reputation relative to its competitors.
Rating agencies can be too conformist, too conservative, or too bold precisely because they worry about reputation. Even if conflicts of interest were not an issue, governments and regulators should be cautious in giving rating agencies quasi-regulatory powers.