A Strict Liability Regime for Rating Agencies

Abstract

This paper argues that a mitigated strict liability regime can incentivize Credit Rating Agencies (CRAs) to produce ratings as accurate as the available forecasting technology allows. A damage cap based on objective factors is introduced in order to avoid crushing liability. Moreover, CRAs are allowed to choose how much to commit to their predictions. CRAs may opt out of liability even entirely, unless their ratings are relevant for regulation. Finally, corrections in the relevant timeframe for the imposition of liability are introduced in order to protect CRAs from systemic risk.

Keywords: law & economics; financial regulation; rating inflation; probability of default; crushing liability; imperfect foresight; systemic risk; structured finance

JEL Classification: G01; G24; K13; K22