Centre for Economic Policy Research

50 Conflicts of Interest in the Financial Services Industry

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4.7.2
Reduce existing regulatory privileges
The reduction of existing recognitions by financial regulators would be a step in
the direction of increasing the operation of market discipline on the industry.
Critics of the industry have often argued that the demand for ratings arises 
mainly because of the regulatory use to which they are put, rather than to the
additional information they convey (White, 2001; Partnoy, 1999). Regulatory
privileges do not in themselves create a conflict of interest, but they may increase
the incentive to exploit a latent conflict of interest, as well as raising the barriers
to entry in the industry.
We see some justification, therefore, for reconsidering the uses to which ratings
are put for regulatory purposes. Such uses have clearly expanded beyond what was
intended when some rating agencies were granted recognized status as NRSROs
(Securities and Exchange Commission, 2003a). It seems that those who have
granted such recognitions also have reservations about the extent to which they
have been used (Nazareth, 2003). The issue, however, is whether financial 
regulators have viable alternatives. 
Regulators of financial institutions have been moving increasingly in the 
direction of ‘risk-based supervision’. They have made financial institutions’ risk
management systems subject to supervisory review and have required minimum
capital levels to be related to measured risk. To the extent that measuring risk
involves an assessment of the asset portfolio of the supervised institution, some
means of assigning credit risk weights to individual claims will be needed. Publicly
available ratings provide a convenient way of doing this, without involving the
regulator in detailed, resource-intensive and controversial judgements. It is 
probably unrealistic to expect supervisors to abandon this tool in the short term.
Still, we do not believe that this is the optimal solution for the long term.
Supervised financial institutions should be encouraged to develop in-house 
credit assessment techniques (something that is already happening), which could
then be reviewed on their own merits by the supervisor, rather than cross-checked
for compatibility with published ratings. Where publicly traded securities are 
concerned, greater reliance on market judgements (as revealed in credit spreads,
for example) could be used. 
Our view, therefore, is that the increasing official reliance on private ratings is
problematic and reducing it would be a reasonable objective of public policy. It
would allow market disciplines over rating agencies to work much more 
effectively. In the interim, a less far-reaching move would be to ease the barriers
that existing procedures present to the recognition of new agencies, while finding
alternative techniques to guard against competitive laxity in the rating industry.