Credit Rating Agencies in Canada: Industry Issues and How to Regulate Them

Abstract

The objective of Credit Rating Agencies (CRAs) is to reduce the degree of asymmetric information in capital markets by issuing judgments. These judgments, also known as ratings, provide investors with the likeliness of default of debt issuers and represent valuable input for the global financial system as they allow them to better perceive the risks associated with investing in government/corporate bonds or preferred stock. Despite how useful they are providing an estimation of the credit quality of investment products, CRAs remain open to criticism because of three main issues which were some of the main catalysts of the 2008 financial crisis: 1) The issuer-pays model, 2) lack of competition, and 3) mandatory reliance on ratings. Since then, international financial authorities worldwide have focused on implementing regulations to address the inconveniences regarding the rating process.

This paper deeply reviews the previously enounced issues involving CRAs and it proposes the following policy recommendations for Canada: 1) To make CRAs liable for deliberate malperformance, 2) to improve the central monitoring of CRAs’ activities, and 3) to conduct research on which business models may be more suitable than the issuer-pays model. These recommendations are extensively based on the academic literature about the CRA industry, and the implemented measures in the United States and the European Union.

Keywords: Credit Rating Agencies, Capital Markets, Great Recession, Regulation

JEL Classification: G24