Centre for Economic Policy Research

4.2
The role of rating agencies
Rating agencies play an important role in reducing information asymmetries in
the market for traded debt securities, as well as in the assessment of non-traded
debt. These asymmetries arise because potential purchasers of debt instruments
lack the information or the capacity to assess accurately the creditworthiness of
issuers. The issuers are aware of the true characteristics of the securities they issue,
but are unwilling or unable to communicate this information credibly to 
potential lenders.
White (2001) notes that, if rating agencies do their job well, ‘credit rating firms
can help lenders pierce the fog of asymmetric information that clouds lending
relationships.’ In a speech in February 2003, the President of Moody’s Investors
Services (McDaniel, 2003) explained: 
Rating agencies thus act as ‘delegated monitors’ (Ramakrishnan and Thakor, 1984;
Millon and Thakor, 1985) for holders and potential acquirers of debt. They have
three potential advantages in performing this role:
1. they may be able to devote more resources and specialized expertise to 
credit analysis than individual investors;
2. they may be granted access to information not available to the generality of 
investors;
3. if they are believed to be independent, their credit assessments will have 
greater credibility. 
If rating agencies are used by numerous investors, they can avoid duplication
costs in the gathering and analysis of information. The assessment of creditwor-
42 Conflicts of Interest in the Financial Services Industry
‘...the main and proper role of credit ratings is to enhance transparency and
efficiency in debt markets by providing an independent opinion of 
relative credit risk, thus reducing the information asymmetry between 
borrowers and lenders. We believe this function to be beneficial to the 
market, as it enhances investor confidence and allows creditworthy 
borrowers broader marketability of their debt securities.’

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thiness has always been resource-intensive. It is arguably becoming more so as the
complexity of companies’ financial structures increases. Even if each individual
creditor were capable of performing the required analysis, such an effort would be
wasteful of resources from a social standpoint.
The fact that rating agencies are viewed as delegated monitors for debt-holders
means that issuers may be more prepared to share confidential information with
them than with any individual creditor. They are willing to do so because there is
an economy of effort to convey information once rather than many times, and a
firm may, for legal reasons, be more comfortable sharing sensitive information
(such as longer-term earnings forecasts) with an entity that has no direct financial
stake in the company but will use the information as input to a rating decision
that is available to all market players at the same time.
The absence of a direct financial interest also increases a rating agency’s 
credibility, and hence its effectiveness as a delegated monitor. Users of the rating
agency’s assessments assume that its interest is in preserving its reputation for
high quality, unbiased judgement, and therefore its rating should reflect a 
genuine assessment of the creditworthiness of the company being rated.