Centre for Economic Policy Research

4.6
Vulnerability to conflicts of interest
How far does the structure of the rating industry, as it has now emerged, give rise
to a conflict of interest? The potential for a conflict is clearly created by the fact
that there are multiple users of ratings and, at least in the short term, their 
interests can diverge. The investor is interested in a well-researched, impartial
assessment of credit quality; the issuer in a favourable rating. Regulators are 
interested in a stable relationship between ratings and default risk over time as
well as the avoidance of moral hazard and the distortion of the competitive 
environment. The rating agencies themselves have their own interests as 
commercial enterprises. They are presumably seeking to maximize their revenues
and market value. Moreover, if rating agencies are affiliated to other businesses
(Standard & Poors is part of McGraw-Hill, for example), this can also create the
potential for divergences of interest.
What specific conflicts could these divergent interests give rise to? An obvious
risk is that the ‘issuer fee’ model could result in rating agencies implicitly or 
explicitly offering more favourable ratings in exchange for business. Since most
bond issues are rated anyway, one could ask ‘what exactly do issuers think they
are paying for?’ We referred earlier to the suspicion that could arise that payment
for a rating led to more favourable treatment. As we will discuss later, any overt
quid pro quo of this sort would tend to undermine an agency’s reputation for
impartial analysis, and thus the basis of its franchise. It seems unlikely, therefore,
that it would arise in such a blatant way.
There are, however, two other mechanisms through which this type of conflict
might come into play. One is if the compensation arrangements in a rating firm
rewarded analysts for securing additional ratings business, an incentive for lenient
treatment would be created. 
The second is more conjectural. The behavioural finance literature has 
recently identified ways in which agent bias can arise, even when financial incen-
tives have been removed, and agents believe themselves to be acting objectively.
Moore et al. (2002), for example, undertake an experiment in which an agent who
has been closely involved with one party to a transaction is subsequently placed
in a position where they have no direct financial incentive, and is asked to act
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objectively. Placed in such a situation, agents nevertheless tended to adopt 
positions favouring the party with whom they had previously worked. Moore et
al.’s test was in the context of auditing, but if valid, could also apply in the case
of a rating agency analyst that had worked closely with a client firm.
A potential source of conflict could also arise in the ancillary businesses that
rating agencies have recently begun to develop (Fitch, 2003). Rating agencies are 
increasingly offering advice on the structuring of debt issues, usually to help
secure a favourable rating. Such consultancy business has aspects in common with
the advisory business developed by accounting firms. Rating agencies have 
developed this business because clients often want to create financial structures
that have a low probability of default and have this recognized by the market in
favourable borrowing terms. To do so, they need the institutions that certify 
credit quality to give them a high rating. These institutions themselves are most
familiar with their rating methodology. So they can charge for helping design a
structure that will be accorded the desired credit rating. In this case, however, the
credit-rating agency would be in the position of ‘auditing its own work’. 
Several observers have also noted that the increased use of ratings for 
regulatory purposes has implications for the extent and nature of vulnerability to
conflicts of interest (White, 2001; Partnoy, 1999). For instance, it might increase
the incentive to shop for the best rating, as the value of such a rating is increased
when it results in a relaxation of regulatory constraints. For rating agencies, the
acceptance of their rating for regulatory purposes greatly increases their franchise
value.
Regulatory recognition also has the capacity to contribute to moral hazard.
Market participants may misconstrue recognition as approval of the methodolo-
gy used by rating agencies or of the ratings that result. They may therefore come
to rely on rating assessment to a greater extent than would be justified by the
additional information it contains. This in turn would complicate the task of
judging the accuracy and effectiveness of rating. The observed influence of 
ratings’ judgements on the market price of traded instruments could be the result
of a false assumption that ratings convey more information than they in fact do
(Partnoy, 1999).
Another potential source of vulnerability to conflict of interest could arise from
concentration in the industry. The rating industry is dominated by a small 
number of players. In the United States, for example, there are currently only four
NRSROs, and of these, two (Moody’s and Standard & Poors) are much larger than
their two competitors. Most other jurisdictions have even less competition
(White, 2001; Bank for International Settlements, 2000). It is widely believed that
the combination of economies of scale and regulatory privileges favouring 
incumbents constitute significant barriers to entry to the industry.
Lack of competition has offsetting implications for conflicts of interest. On the
one hand, it could help reduce conflicts, since agencies will not be under 
short-term pressures to shade their judgements in order to win business. The 
business will come to them anyway, and they will be more conscious of their
interest in maintaining reputation and discouraging the entry of competitors in
the longer term. On the other hand, since the competitive position of the 
agencies is assured, they have less incentive to provide the best possible service.
This could lead them to devote fewer resources (in quantity or quality) to the 
credit assessment process than would be justified by the fees received. They may
also have added incentives to lobby to maintain their favoured status.
White (2001) documents that the profit margins of rating agencies are very
high (up to 50% in the case of Moody’s) so that there is some prima facie reason
for believing that the services delivered do not match the fees paid. Oligopoly
Rating Agencies: Conflicts of Interest in Credit Assessment and Consulting 49

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could lead to a conflict between a rating agency’s private interest in maximizing
its income and the economic function for which it has been given certain 
regulatory privileges, namely the provision of data and analysis that reduces 
information asymmetries.