The Siskel and Ebert of Financial Markets: Two Thumbs Down for the Credit Rating Agencies

Abstract:     
This paper critiques the role of credit ratings and credit rating agencies in providing information about bonds. The dominant "reputational capital" view of credit rating agencies is that the agencies have survived and prospered since the early 1900s based on their ability to accumulate and retain reputational capital (i.e., good reputations) by providing valuable information about the bonds they rate. The paper argues that this view fails to explain, and is inconsistent with, certain types of market behavior including: the estimation of credit spreads, the number of credit ratings-driven transactions, and the explosion in use of credit derivatives.

In place of the reputational capital view, the paper offers a "regulatory license" view of rating agencies as generating value, not by providing valuable information, but by enabling issuers and investors to satisfy certain regulatory requirements. The paper concludes that regulators should eliminate regulatory dependence on credit ratings by substituting a regime based on market-determined bond credit spreads (i.e., the difference between the yield on a bond and the yield on a risk-free bond of comparable maturity). Such credit spreads reflect all available information, including credit ratings, and therefore are more accurate and reliable than credit ratings.

Number of Pages in PDF File: 104

JEL Classification: G2, G28

Accepted Paper Series