Rating the Raters

Credit rating agencies play a crucial role in modern capital markets, but they completely failed in the years preceding the financial crisis. And the problem hasn’t gone away: as long as issuers of securities choose and compensate the firms that rate them, the agencies will have a strong incentive to reciprocate with good ratings – unless they, too, are subject to ratings.

CAMBRIDGE – In the new financial order being put in place by regulators around the world, reform of credit rating agencies should be a key element. Credit rating agencies, which play an important role in modern capital markets, completely failed in the years preceding the financial crisis. What is needed is an effective mechanism for rating the raters.

There is widespread recognition that rating agencies have let down investors. Many financial products related to real estate lending that Standard & Poor, Moody’s, and Fitch rated as safe in the boom years turned out to be lethally dangerous. And the problem isn’t limited to such financial products: with issuers of other debt securities choosing and compensating the firms that rate them, the agencies still have strong incentives to reciprocate with good ratings.

What should be done? One proposed approach would reduce the significance of the raters’ opinions. In many cases, the importance of ratings comes partly from legal requirements that oblige or encourage institutional investors and investment vehicles to maintain portfolios of assets that have received sufficiently high grades from the recognized agencies.

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