The Paradox of Credit Ratings

Abstract:     
Credit ratings pose an interesting paradox. On one hand, rating agencies have great market influence and even greater market capitalization. On the other hand, numerous studies suggest credit ratings are of limited informational value. This paradox - continuing prosperity of credit rating agencies in the face of declining informational value of ratings - has generated extensive debate among commentators.

In this article, I expand on and update a claim I made in 1999 (some have dubbed it a "complaint") that regulatory dependence on credit ratings explains the paradox. Numerous legal rules and regulations depend substantively on credit ratings, and particularly on the credit ratings of a small number of Nationally Recognized Statistical Ratings Organizations (NRSROs). Moreover, the barriers to entering the NRSRO market are prohibitive. The result is that credit ratings issued by NRSROs are valuable to financial market participants even if their informational content is no greater than that of public information already reflected in the market.

In particular, I analyze how these arguments apply to The New Basle Capital Accord, issued for comment on May 31, 2001. I argue that this accord is flawed to the extent it incorporates risk weights that depend on credit ratings, and recommend risk weights based on credit spreads.

In addition, I respond to the argument some scholars have made that rating agencies should not and do not engage in reputation-depleting activity because of the risk of civil liability. In fact, the available evidence indicates that rating agencies' expected civil liability is very low; rating agencies have not paid substantial damage awards in such litigation and by federal statute are immune from certain types of liability.

Working Paper Series