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Credit Rating Agencies and the 'Worldwide Credit Crisis': The Limits of Reputation, the Insufficiency of Reform, and a Proposal for Improvement

John P. Hunt

University of California, Davis - School of Law

September 5, 2008

Columbia Business Law Review, Vol. 2009, No. 1

The "worldwide credit crisis" has thrust credit rating agencies into the spotlight, with attention focused on their ratings of novel structured finance products. Policymakers have undertaken a number of initiatives intended to address perceived problems with such ratings - enhancing competition, promoting transparency, reducing conflicts of interest, and reducing ratings-dependent regulation. These approaches are all broadly consistent with the dominant academic theory of rating agencies, the "reputational capital" model, which is taken to imply that under the right circumstances a well-functioning reputation mechanism will deter low-quality ratings. The policy initiatives currently under consideration can be seen as efforts to fix discrete problems with the rating market so that the reputation mechanism can work properly.

This Article argues that these efforts are fundamentally incomplete, because even a well-functioning reputation mechanism does not generate optimum rating quality on new products: When a new product is introduced, agencies do not have a reputation for high quality in that product so they have nothing to lose from issuing the rating. Even if low quality for a specific product type harms the agency's reputation for rating other product types, the agency still will be induced to issue low-quality ratings if the new product type in question is large enough in volume. And as long as rating quality across new product types is high enough on average, it is rational for investors to rely on new-product ratings even if they know that some are of low quality.

The incentive problem can be corrected by requiring an agency to disgorge profits on ratings that are revealed to be of low quality by the performance of the product type over time, unless the agency discloses that the ratings are of low quality. Such a system would be superior both to the current regime, which relies on market forces backed by antifraud rules, and to other alternatives, such as the recent proposal to forbid new-product ratings absent prior SEC approval of the products.

Number of Pages in PDF File: 74

Keywords: rating agencies, credit crisis, reputation, SEC, financial regulation

JEL Classification: K22

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Date posted: September 14, 2008 ; Last revised: January 25, 2009

Suggested Citation

Hunt, John P., Credit Rating Agencies and the 'Worldwide Credit Crisis': The Limits of Reputation, the Insufficiency of Reform, and a Proposal for Improvement (September 5, 2008). Columbia Business Law Review, Vol. 2009, No. 1. Available at SSRN: http://ssrn.com/abstract=1267625 or http://dx.doi.org/10.2139/ssrn.1267625

Contact Information

John P. Hunt (Contact Author)
University of California, Davis - School of Law ( email )
Martin Luther King, Jr. Hall
Davis, CA CA 95616-5201
United States
(530) 752-5052 (Phone)
HOME PAGE: http://ratingagencylawblog.wordpress.com/

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