Centre for Economic Policy Research

particularly asset-backed securities, to reveal more information and so produce
better credit ratings and a greater flow of credit. A unique advantage of the rating
agencies, however, is that they have proprietary knowledge of their own 
assessment procedures, and therefore can supply clients with greater assurance
that their advice will produce the desired result, that is, a lower rating. Moreover,
given the regulatory advantages that will flow from a positive rating judgement,
clients have an added incentive to use the rating agencies advisory services. This
could be an artificial source of comparative advantage, rather than a genuine 
synergy. Thus, although we do not advocate prohibition of rating agencies
involvement in these consulting activities, we do believe that supervisory 
oversight may be needed to make sure that conflicts of interest of interest do not
damage the provision of information from rating agencies.
4.7.6
Establish a regulatory regime
The most far-reaching solution to the alleged problems in the rating industry
would be to establish a formal system of oversight of the agencies, such as exists
for banks, securities firms, and insurance companies.
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The case for a regulatory
regime is that, in the absence of such a regime, the market will produce distorted
incentives with attendant negative externalities for the economy at large. The case
against it is that official intervention will smother beneficial market incentives,
encourage moral hazard, and permit the intrusion of extraneous objectives
favoured by the political process.
In general, we are skeptical that a fully developed regulatory regime would 
produce the desired results. We do not see how it would promote genuine 
competition, generate improvements in the judgements made by rating agencies,
or result in the provision of higher quality information to the market-place. It is
more likely, in our judgement, to result in formalistic procedures and less 
effective competition. 
Moreover, there is the question of how such a regulatory regime would be 
justified. Rating agencies have frequently stressed that what they provide are 
simply opinions and are thus protected by the First Amendment to the US
Constitution, and similar free speech provisions under constitutional 
arrangements in other jurisdictions (Fitch, 2003). It seems unlikely that a direct
attempt to regulate rating agencies would be successful, even if it were thought
desirable.
Any supervisory approach would therefore have to work through limitations to
existing regulatory recognitions. In other words, where ratings are currently
allowed for certain regulatory purposes (such as assessing risk weights for capital
adequacy purposes) they could be disallowed for agencies not following 
rules. This seems a disproportionate response to the problem at hand, and one
Rating Agencies: Conflicts of Interest in Credit Assessment and Consulting 53

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that goes contrary to our preferred approach of reducing regulatory recognitions
and relying increasingly on market disciplines.