Centre for Economic Policy Research

40 Conflicts of Interest in the Financial Services Industry

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4 
Rating Agencies: Conflicts of Interest in 
Credit Assessment and Consulting
4.1
Introduction
The significance of ratings in the financial system has expanded materially in
recent years. Ratings are widely used by investors as a guide to the creditworthi-
ness of the issuers of debt and in financial covenants. As such, they play a major
role in the pricing of debt securities and whether particular securities are eligible
to be held by particular types of investor. Changes in ratings have come to be used
as ‘triggers’ in financial contracts, with downgrades requiring actions such as the
posting of additional collateral, an adjustment in interest rates, or even the 
termination of the contract. Regulators, too, have placed additional weight on
credit ratings for constraining the portfolio decisions of fiduciary intermediaries,
assessing the risk level of their portfolios, and determining the size of the 
minimum capital cushion they are required to hold.
In addition, ratings have increasingly influenced the behaviour of borrowers
and potential borrowers. Companies often structure their borrowing in order to
achieve a desired rating. They have also established special-purpose entities with
a view to receiving a higher rating for a portion of their obligations, thus 
reducing their borrowing costs.
As ratings have become more influential, the work of the rating agencies has
come under closer scrutiny. Following the Asian financial crisis of 1997-8, the
agencies were widely criticized for being too slow to recognize the deteriorating
situation in Asian banking systems, and then for being too precipitate in 
downgrading the affected countries, thus compounding and spreading the 
original problem (Bank for International Settlements, 1999). Greater scrutiny by
official bodies in industrial countries was triggered by the collapse of the Enron
Corporation in December 2001, followed by a wave of corporate scandals. Enron
enjoyed an investment grade rating until four days before its failure. Moreover, its
business strategy and financial structure, especially the off-balance sheet special
purpose entities, were strongly influenced by the objective of maintaining a high
rating.
The US Congressional committee investigating the collapse of Enron found
that the rating agencies had displayed ‘a disappointing lack of diligence in their
coverage and assessment of...’ Enron (US Congress, 2002). As a result, the
Sarbanes-Oxley Act mandated the SEC to prepare a report on ‘The Role and
Functioning of Credit Rating Agencies in the Operation of the Securities Markets’.
This report has two parts. The first part (Securities and Exchange Commission,
2003a) is mainly descriptive, outlining some of the potential sources of concern
about the agencies, reviewing earlier enquiries into their activities and discussing
aspects of the functioning of the industry. The second part (Securities and
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Exchange Commission, 2003b) is likely to suggest possible remedies. Other 
countries share many of the worries of the US authorities but have decided to
await the outcome of the SEC investigation before reaching conclusions on what
initiatives to take themselves (Financial Stability Forum, 2002).
The first part of the SEC’s report raised the following important questions:
1. Should more information be released by rating agencies about their 
decisions, and should more information by issuers be disclosed?
2. Should improved procedures be introduced to avoid or manage potential 
conflicts of interest?
3. Is there any basis to allegations of anticompetitive behaviour in the 
industry, and if so, what should be done about it?
4. How, if at all, should rating agencies be recognized for regulatory purposes?
5. Should oversight of rating agencies be changed?
In this chapter, we address these basic questions and assess what remedies may be
required to manage any existing or emerging conflicts of interest.