Credit rating agencies have become an essential part of the financial landscape. These private companies assess credit risk for companies and governments seeking to take out loans and issue fixed-income securities, such as bonds. Reliance on these agencies is so entrenched that prospective borrowers often must obtain a credit rating before they try to raise money in capital markets. The ratings provide prospective lenders with guidance on the borrower’s creditworthiness, which contributes to the determination of the interest rate, or price, the borrower must pay for financing.
But these private rating agencies’ assessments, which are designed for private financial markets, have been inserted into the public domain—regulators across the globe use them, for example, to assess the riskiness of bank portfolios and determine how much capital institutions must hold to guard against insolvency. With regulators’ growing emphasis on risk as the basis of capital adequacy, the credit rating agencies’ assessment of that risk has, in effect, been turned into a public good.
Putting credit rating agencies—mainly Standard & Poor’s, Moody’s, and Fitch (see Box 1)—into the public regulatory domain has had two consequences. First, it changed the nature of banking regulation from reliance on static, fixed percentages to use of dynamic scores that can change according to a rating agency’s assessment of credit risk. This introduced greater sophistication, but also greater complexity and the possibility of incorrect, outdated, or otherwise misleading risk assessments. Second, it led to the entrenchment of private entities in regulation—a domain normally reserved for the public sector. Most discussion of rating agencies has focused on conflict of interest and other problems as they relate to assessment quality. Far less has been said about the potential for a serious conflict of interest between the objectives of privately owned credit rating agencies seeking to maximize shareholder value and the objectives of the regulatory role they play, even if they did not seek that role.
As authorities reexamine the regulatory and supervisory failures during the run-up to the global crisis, they must look at the reliance on credit rating agencies. Although any assessment must take into account the costs of making changes, there are a variety of potential paths—including reforming the rating agencies, bringing them under public control, or finding alternatives to them.
Bank for International Settlements Basel Committee on Banking Supervision (BIS), 2009, “Stocktaking on the Use of Credit ratings,” Joint Forum Working Group on Risk Assessment and Capital (Basel).
Katz, Jonathan, Emanuel Salinas, and Constantinos Stephanou, 2009, “Credit Rating Agencies: No Easy Regulatory Solutions,” World Bank Crisis response Policy Briefs, Note Number 8 (Washington).