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Credit Rating Agencies in Capital Markets: A Review of Research Evidence on Selected Criticisms of the Agencies

45 Pages Posted: 1 Jun 2006  

Carol Ann Frost

University of North Texas

Multiple version iconThere are 2 versions of this paper

Date Written: March 15, 2006

Abstract

This study assesses the validity of widespread criticisms of the large, nationally recognized credit rating agencies (CRAs). The criticisms focus on these CRAs' (1) disclosure practices (such as related to the assumptions underlying their ratings decisions); (2) potential conflicts of interest; (3) alleged anticompetitive or unfair practices; and (4) diligence and competence. This paper focuses on two questions. First, to what extent does empirical evidence support the criticisms? Second, what additional evidence might be useful?

Although little rigorously-gathered empirical evidence supports the criticisms, the absence of such evidence does not indicate that the criticisms are invalid. First, powerful tests related to potential conflicts of interest and alleged unfair practices are exceptionally difficult to design. Second, criticisms related to the adequacy of CRAs' disclosure practices have not yet been, but could be, investigated by empirical researchers. Third, many criticisms, particularly those focusing on the adequacy of CRAs' disclosure practices, diligence, and competence, are based on subjective benchmarks that are difficult to quantify (and that themselves are open to question).

Empirical evidence does support the view that the large CRAs' dual roles of (1) providing timely information to market participants; and (2) serving regulatory and contracting functions, create conflicting incentives. Note, however, that the costs of these conflicts may be less than those of other alternatives. Researchers should further investigate how conflicting incentives affect CRA practice, and develop and test models of how CRAs optimize across their conflicting rating goals. Researchers have many other opportunities to make important contributions. For example, further study of factors that influence characteristics of credit ratings, such as timeliness, stability, and accuracy, is warranted.

Keywords: Credit rating agencies, Capital markets, U.S. Securities and Exchange Commission, Disclosure, Government regulation

JEL Classification: G18, G14, G28, G20, G33

Suggested Citation

Frost, Carol Ann, Credit Rating Agencies in Capital Markets: A Review of Research Evidence on Selected Criticisms of the Agencies (March 15, 2006). Available at SSRN: https://ssrn.com/abstract=904077 or http://dx.doi.org/10.2139/ssrn.904077

Carol Ann Frost (Contact Author)

University of North Texas ( email )

1155 Union Circle #305340
Denton, TX 76203
United States
(940) 565- 3069 (Phone)
(940) 565-3803 (Fax)

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