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How to Reform the Credit Rating agencies

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Major credit rating agencies are severely criticized for beautifying the bad credits of financial institutions with AAA ratings that led to financial crisis. There has been lots of discussion on reform of CRAs. There was a round table organized by SEC to examine oversight of agencies. Recently, they met on September and came up with a paper with adopted rule and proposed rule. World bank maintains a page devoted to ideas on CRAs reform. There has been deluge of working papers identifying the loophole in earlier set up, and proposing remedial measures.

The major problem has been the obvious conflict of interest. CRAs are paid by institution who they have to rate, and to attract more businesses CRAs began assigning superior ratings to financial products and institution. A recent paper suggests that CRAs are more prone to inflate rating when there is a larger fraction of naive investors, and reputation risk of getting caught of CRAs is lower.

There has been suggestion like CRAs revenue source should be people who benefit from their service, that is investors. But, due to practical difficulty in implementing a model like this, the idea don’t have much supporter. The second idea that came to fore is, why shouldn’t we have number of small CRAs like equity research teams.  Now, we have only three CRAs, Moody’s, S&P and Fitch rating. The proposed suggestion relies on assumption that number of CRAs will make the market competitive, hence it will become efficient and honest. The concept was correct, but unfortunately it has not worked properly for equity research as well, and retail investors continue to be fed with misinformation.

Another idea is to have rotating raters. It says that every tenth rating  by a CRA would be subjected to back rating. The idea is good, but yet again it adds to complexity and there is a possibility of back rating agencies to be as lenient as first rating agency. Some are suggesting joint liability scheme where if one rating agency is sued and can’t pay investor restitution, then other rating agency should be forced to pick up the tab. They say it will force all three to raise their bar, but few doubt that it would have opposite effect, as rating agencies are getting insured for it’s bad performance.

We have to wait and watch that what are the measures SEC adopts to reform credit rating agencies.

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Written by SK

October 9, 2009 at 3:50 pm

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