Enhancing the Accountability of Credit Rating Agencies: The Case for a Disclosure-Based Approach
Université de Montréal - Faculty of Law
CREDIT RATING AGENCIES: NEED FOR REFORM IN CANADA?, 2005
Credit rating agencies (CRAs) play a vital role in enabling financial markets to operate efficiently by acting as informational intermediaries specializing in the appraisal of the creditworthiness of corporations that issue debt. Gradually, they have become central to the financial markets' infrastructure through their role in rectifying information asymmetries that exist between issuers and investors. Concurrently, CRAs have gained considerable clout over market participants, as their assessments of creditworthiness have come to be viewed as authoritative. Despite their importance, however, rating agencies remain unregulated private institutions.
The recent wave of corporate scandals has led many to call their contribution to market efficiency into question. In light of such criticism, studies conducted by lawmakers and regulators sought to further examine the role and effectiveness of CRAs. Although the studies revealed no particular wrongdoing on the part of CRAs, they warned of potential problems that could disrupt the smooth operation of capital markets. These problems relate to the reliability and integrity of ratings, as well as to possible anticompetitive practices on the part of CRAs. These potential problems are worrisome given that CRAs wield considerable power over issuers and investors through the information disseminated in their ratings.
Fundamentally, the main theme underlying the criticism of CRAs relates to their accountability towards market participants. In a perfectly functioning market, the fact that CRAs have such significant power would not elicit such concern since they would be accountable to both issuers and investors. The real world departs from this ideal and market failures may lead to a divergence between, on the one hand, the interests of CRAs, and, on the other hand, those of issuers and investors. Two market failures are noteworthy in this regard: imperfect competition and agency problems. A review of the legal and institutional environment surrounding CRAs indicates that there is a dearth of mechanisms designed to offset these markets failures and to ensure CRAs' accountability toward issuers and investors. In fact, it would appear that reputation is the primary, if not the only mechanism that acts to restrain opportunistic behaviour on the part of rating agencies. Thus, a potential accountability gap exists.
It is in this context that regulators have examined possible methods of enhancing the accountability of rating agencies. The International Organization of Securities Commission (IOSCO) published the Code of Conduct Fundamentals for Credit Rating Agencies aimed at ensuring the quality and integrity of ratings. The Securities and Exchange Commission (SEC) has proposed a rule that would define the conditions an entity must satisfy in order to obtain a Nationally Recognized Statistical Rating Organization designation. In light of the recent flurry of regulatory initiatives, the purpose of this study is to discuss the attitude that Canadian regulators should adopt in approaching CRA accountability. The study argues that the IOSCO Code is better suited to implementation in Canada than the SEC rule, which is idiosyncratic to the American system. The study proposes implementing the IOSCO Code through a disclosure strategy.
Number of Pages in PDF File: 63
Keywords: Credit rating agencies, securities regulationAccepted Paper Series
Date posted: November 2, 2005
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