Reducing Over-Reliance on Credit Rating Agencies
| DOI | 10.1177/1023263X1502200502 |
| Published date | 01 October 2015 |
| Date | 01 October 2015 |
| Author | Phoebus L. Athanassiou,Aikaterini Theodosopoulou |
| Subject Matter | Article |
656 22 MJ 5 (2015)
ARTICLES
REDUCING OVER-RELIANCE ON
CREDIT RATING AGENCIES
State of Play and Challenges Ahead
P L. A and A T*
ABSTRACT
is paper provides an overview of recent credit rating-related initiatives in the US and
EU, including those at the level of some of the world’s leading central bank s, together with
an assessment of the remaining challenges. e authors argue that (i) notwithstanding
concerns over the objec tivity and reliability of their ratings, credit rating agencies have, by
and large, o ered reasonably good estimates of credit quality, (ii) careful consideration is
necessary before settling with alte rnatives, as opposed to complements, to their ratings, (iii)
greater transparency in issuer nancial information, and improvements in the internal
ass essme nt capa biliti es of nancial rms are pre-requi sites if reliance on credit ratings is to
be further reduced. e authors also conclude that, while central bank s have done a lot to
reduce their reliance on credit ratings, any further de coupling of their collateral frameworks
from credit ratings, beyond the eld of sovereign issues, will pose a con siderable challenge
for them.
Keywords: credit rati ngs; nancial crisis; over-reliance; policy response
§1. INTRODUCTION: THE GOOD AND THE UGLY SIDE OF
CREDIT RATING AGENCIES
By assessing the cred it risk of corporate and sovereign borrowers and issuers of xed-
income debt instruments, and by analysing information available on the nancial
* e authors are Princ ipal Legal Counsel and Le gal Counsel wit h the legal services of the Eu ropean
Central Ba nk (ECB). e views expressed in t his paper are solely those of the authors , and are not
intended to represent th ose of the ECB or the Eurosys tem.
Reducing Over-Reliance on Credit Rating Agencies
22 MJ 5 (2015) 657
circumstances of issuers or borrowers and their markets, credit rating agencies (CRAs)
have a key role to play in the operation of the international na ncial system. rough their
ratings – which represent opinions as to t he likelihood that the is suers of debt instruments
will meet t heir contractual obligations v is-à-vis holders, as these fal l due, rather than buy
or sell recommendations1 – CRAs provide standardized, easi ly accessible third-party
assessments of credit qualit y.2 Moreover, by relying on a mixture of both qua ntitative
and qualitative indicators3 to assess the probabilit y of default or expected loss,4 credit
ratings can help reduce the ‘infor mation asymmetry’ between issuers (as borrowers) and
holders (as lenders-investors). By providing independent credit assessments, CRAs can
also boost market participation, contributing to ‘deeper’ (that is, more liquid) markets.5
In the words of a commentator,
the debt-rating agency i s in this sense a solution to the classic ‘ma rket for lemons’6 problem
(…) given the prospect of fraud and default, a n issuer will be force d to pay the interest
rate applicable to the average quality issuer unless it can credibly signal its superior credit
to the market (…) Such a market and ine cient average cost pricing ty pically ari se when
the individua l competitor cannot cre dibly distingu ish its product from the herd of sim ilar
products.7
Besides, credit ratings c an mitigate the advantage of some investors over others in terms
of better judgment-calls over issuer cre ditworthiness: by helping to place investors on an
equal footing, credit ratings serve as ‘equal izers’ in the xed-income capital markets.8
Finally, CRAs have assumed a ‘certi cation’ role, with their ratings serving as credit-
1 IOSCO, Technical Comm ittee of the International O rganization of Secur ities Commissions, e role
of Credit Rating A gencies in Struct ured Finance Markets, Fina l report, May 2008, p.3. e IOSCO
CRA Code of Conduc t in 2008 de nes a credit rati ng as ‘an opinion regarding t he creditworthi ness of
an entity, a credit com mitment, a debt or debt-like secu rity or an issuer of such obli gations, expressed
using an establ ished and de ned rank ing system’ (ibid., p.4).
2 H. McVea, ‘Regulating Cred it Rating Agencies i n the European Union: W here Might it Lead?’, 83
AMICUS CURIAE (2010).
3 Examples of quantitative indicators include nancial data, ratios and mod els, while exa mples of
qualitative i ndicators include busines s risks, regu latory changes, t he quality of mana gement and future
industry outlooks.
4 IOSCO, ‘Good Practices on Reducing Reliance on CRAs in asset management’, Consultation Report
-CR 04/14 , June 2014.
5 P. Deb et al., ‘Whither the Credit Ratings Industry’, Bank of England Financial Stabilit y Paper No. 9
(2011), www.bankofengl and.co.uk/publications/ Documents/fsr/fs_paper09.pdf.
6 G.A. Akerlof, ‘ e Market for “Lemons”: Quality Uncerta inty and the Marke t Mechanism’, 84 e
Quarterly Jour nal of Economics (1970), www.econ.ucsb.edu/~tedb/Courses/Ec100C/Readings/
lemonsakerlof.pdf, p.4 88–500.
7 J.C. Co ee, Gatekeepers: e Profes sions and Corporate Go vernance (Oxford University P ress, 2006).
8 A. Carron, P. Dhryme s and T. Beloreshki, ‘Credit R atings for Struct ured Products – A Revi ew of
Analyt ical Methodologies, Credit Ass essment Accuracy, and Issuer Select ivity among Credit Rating
Agencies’, NERA Economic Consulting (2003), www.nera.com/ex tImage/6384.pdf ; and S. Schwarcz,
‘Pri vate O rder ing of Publ ic Mar kets : e Rat ing Agency Paradox’, Univ. of Illinois L aw R. (2002), http://
papers.ssrn.c om/sol3/papers.cfm?abstract _id=267273, p.1.
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