Investor Owned and Controlled Rating Agencies: A Summary Introduction

Abstract:     
Rating agencies have been broadly criticized for their failure to anticipate a range of credit market conditions. The dominant critique, voiced by the President of the United States, the Chairman of the SEC, leading members of Congress, and foreign regulators, is that the leading rating agencies are subject to inherent conflicts of interest arising from the “issuer-pays” model that drives their business: Because these rating agencies are paid by the issuers of the securities they rate, the agencies have embedded incentives to please the sources of their essential cash flow and therefore are neither as objective nor as critical as they might be if driven by an alternative business model.

Proposals for reform currently under consideration by Congress and the SEC, however, do nothing to alter these basic incentives. They fiddle at the edges of the marketplace and leave untouched the fundamental incentive conflict about which policymakers appear to agree.

This article suggests an alternative regulatory strategy. Under existing statutory authority, the SEC could create a new category of rating agencies - Investor Owned and Controlled Rating Agencies (“IOCRAs”) - and require that every rating issued by an issuer-paid Nationally Recognized Statistical Rating Organization (“NRSRO”) that is not an IOCRA, such as Moody’s and Standard & Poor’s, be accompanied by at least one rating issued by an IOCRA. Because IOCRAs would be under the control of the sophisticated investor community, and because any one investor’s ownership interest in an IOCRA would be capped, the incentives of IOCRAs should be oriented to generating ratings that accurately reflect the risks of holding specific debt instruments, even though their fees would be also paid by issuers. This regulatory strategy introduces immediate competition into a market that is a strong duopoly and incentivizes innovation that has been lacking. Most significantly, however, IOCRAs would constitute rating agencies with an inherently investor-oriented perspective, and if IOCRAs were to fail in anticipating credit market issues, the investor community would, at the end of the day, have only itself to blame.

Number of Pages in PDF File: 15

Keywords: credit rating agencies, financial regulation, U.S. Securities and Exchange Commission, disclosure, government regulation, risk analysis, capital markets

JEL Classification: G14, G18, G21, G28, G32, G38

working papers series