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Thursday, 22 December 2011

Credit Rating Agencies

There is a pretty good update about the status of credit rating agencies (CRAs) in the November 28 issue of Bloomberg Businessweek, p. 51. Parenthesis: what does this have to do with media? Well, CRAs are media: B2B media. Anyway, I find this industry fascinating with complex incentives, eclectic, legacy regulation and - of course - a lot of impact for only a handful of firms. I devoted an entire section in my book to this topic.

Of course after the crisis (in fact, after each crisis) remedies were proposed by the government, part of the famous Dodd-Frank act. The basic intention was to remedy the problem of conflict of interest whereby the agency is paid by the issuer of bonds and rates these bonds in return. Note that only the traditional (the big 3) agencies revenue model is such. The article shows that not much progress has been achieved to mitigate this problem. With the recent miss of MF Global by agencies it is clear that the industry still functions badly.

The article also mentions a new firm paid by investors rather than issuers. This of course takes care of the conflict of interest problem. However, it creates a freeriding problem from customers. Not surprisingly, despite encouragement for newer firms to enter the industry the big 3 still massively dominate. But this is a dangerous game for financial markets.

Here, it is important to get regulation right on two dimensions. First, w.r.t. the conflict of interest. I believe that this cannot be totally eliminated but it could be controlled (by for example randomly assigning some initial ratings - a similar idea was introduced for accounting firms). But more importantly, it would be crucial to make sure that the oligopoly of credit rating become larger with at least a dozen or so firms not just in the US but also from Europe and Asia. Healthy competition would go a long way solving the current issues.

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