Centre for Economic Policy Research

4.7
Remedies to conflicts of interest 
4.7.1
Market discipline 
Rating agencies have usually contended that potential conflicts of interest are in
practice limited by market forces and that attempts to impose regulatory remedies
are neither necessary nor desirable (Fitch, 2003). It is certainly true that market
forces are often capable of finding solutions to information asymmetries. Indeed,
the history of the rating industry itself is that of market solutions to perceived
conflicts of interest. The institutionalized separation of saving and investment in
modern economies created a demand for information-generating intermediaries,
including informational service firms such as rating agencies.
The market mechanism by which conflicts are controlled for rating agencies is
that of ‘reputational capital’. To the extent that if an intermediary is viewed as
being conflicted, the demand for its services is likely to be curtailed. This creates
an incentive for the intermediary to find ways of certifying its objectivity, in order
to protect its reputational capital. If it is unsuccessful in doing so, then the 
market will seek out information-generating sources that are not conflicted. 
The ‘market solution’ to the problem of potential conflicts of interest at rating
agencies is to allow reputation to police any temptation on the part of the 
agencies to shade their judgement in order to favour debt issuers that pay for
ratings. The argument is that a rating agency’s franchise depends on its stock of
reputational capital, and any compromise with objectivity would cost more in
diminishing the stock of reputational capital than it would yield in additional
fees. Eventually, failure to maintain high quality and objectivity in credit assess-
ment would draw competitors into the industry.
While this argument is compelling in many markets, it may be limited for 
ratings agencies. First, the loss of reputational capital is likely to take place gradu-
ally. Biased judgements by rating agencies would probably not become visible
until some time had passed, probably not until the down-phase of the cycle, when
the externalities would be most damaging. The mechanism, therefore, while pow-
erful, may not by itself be sufficiently timely to avoid substantial costs. Second,
although a rating firm will have a strong interest in maintaining its reputational
capital, this does not necessarily apply to individual agents within the firm. As
was demonstrated in the case of auditors, an individual office or manager may
have an interest in cultivating a particular client, even at the expense of the firm’s
long-run reputational capital. Establishing appropriate compensation arrange-
ments within the industry is therefore important. By far the most important fac-
tor is, however, that the ratings industry is not a fully competitive market. There
are a limited number of competitors, and significant barriers to entry. Regulatory
privileges have distorted the incentives within the industry and altered the 
behaviour of its users. 
These considerations tend to weaken the power of market discipline and 
suggest it may be necessary to contemplate ways in which this discipline might be
reinforced or supplemented.