Financial Stability Paper No. 9
By Pragyan Deb, Mark Manning, Gareth Murphy, Adrian Penalver and Aron Toth
Credit rating agencies originally emerged as private companies offering investors considered opinions on the credit quality of borrowers. But while they continue to perform this function, their role has expanded over time. Credit ratings are now heavily hardwired into financial contracts, investment processes, and the regulatory framework. Rating agency decisions therefore have potentially systemic consequences. Many policymakers and commentators have argued that the crisis was exacerbated by a combination of faulty ratings methodologies, conflicts of interest, and overreliance on ratings by banks, investors and regulators. Credit rating agencies have therefore come under close scrutiny in recent years and new legislation has been passed in both the United States and Europe that brings them further within the regulatory perimeter. This paper describes the current role of rating agencies, examines the failures observed during the crisis, and considers the public policy response. It argues that rating agencies perform a valuable role, but that the common and often mechanistic reliance on ratings for information, certification and regulatory purposes lies beneath many of the problems observed during the crisis. The policy priority should therefore be to reduce the scope of such reliance, but to the extent that CRAs nevertheless retain a strong influence in financial markets there may also be a case to consider structural measures to directly tackle potential conflicts of interest in the way in which ratings are produced.