Credit Ratings: Is Competition Good?

Beatriz Mariano has written a VoxEU column regarding her development of a model for Credit Rating Agency behaviour. The paper is titled Do Reputational Concerns Lead to Reliable Ratings? and, somewhat surprisingly, the answer is ‘Not really’.

This paper studies the behavior of rating agencies, in particular it looks at their incentives to issue a rating that is not justified by the private information collected about the project they are rating in a framework in which they value reputation. The model finds that reputational concerns are not enough to prevent deviations from the private signal, in fact these concerns might end up being the driving force behind these deviations. A rating agency whose private signal is perfect issues this private signal as a rating but a rating agency can make mistakes may end up ignoring the private signal and issuing the rating that minimizes reputational costs. Despite its simplicity, the model can motivate several patterns of behavior. In the monopolistic setting, a rating agency is conservative in the sense that it issues too many bad ratings ignoring private and even public information that indicates that the project is good. Competition forces rating agencies to be more aggressive to make sure that they continue being hired and are not replaced by the competitor. Hence, reputational concerns combined with competition originate boldness as rating agencies issue too many good rating ignoring private and even public information that indicates that the project is bad.

The model clearly illustrates how reputation and informational issues can distort ratings. Competition might not solve the incentive problems faced by rating agencies unless it is combined with better models of risk assessment, which would improve the quality of rating agencies assessments, more transparency in that rating’s procedures, and measures to improve monitoring and accountability in the ratings industry.

Her argument is good, but there are no data to test her hypotheses. As with every other attempt to dissect this problem, we have the basic problem that it is impossible to regulate accurate predictions of the future.

I may as well say it again: special access by the agencies to material non-public information must be revoked.

Leave a Reply

You must be logged in to post a comment.