In the recent financial meltdown there has been countless discussions on where to place the blame and many agrees that the credit rating industry and in particular the credit rating agencies played a signicant role. Credit rating agencies are accused of deliberately inflating ratings and generally being too lax regarding the ratings of some structured products. One reason, for why attention goes to the rating agencies and people argue that ratings are inflated, is the industry's extensive problem with conflicts of interest due to the current business model. In the business model the issuers who are to be rated also pay the fees for the rating. This combined with issuers' choice to shop for the most favorable rating, also called ratings shopping, induces a moral hazard problem by giving the agencies incentive to inflate ratings in contrast to reporting truthfully. The consequence would then be a general rating inflation. In response to the numerous accusations the rating agencies argue that such behavior would be very damaging for them, since their reputation is at stake. They also emphasize their argument by stating that reputational capital is of key importance in the industry. It has therefore been discussed whether reputational concerns are powerful enough to discipline the rating agencies. Furthermore some economists argue that although the business model has been in use since the 1970s the problem with ratings shopping did not arise until recent years when the marked for complex structured financial products grew rapidly. This could indicate that the complexity of the new products also is a significant factor in the financial turmoil. Another point is the fact that competition is somewhat limited in the rating marked due to the SEC's designation of NRSROs (Nationally Recognized Statistical Rating Organizations). The NRSRO label recognizes ratings of chosen rating agencies to be of significant value in investment decisions. This created a barrier to entry in the credit market, and many have therefore argued that inducing competition could reduce the problems in the industry. The objective of this thesis is to analyze rating inflation thus the relevance of the above mentioned points: Whether reputational concerns are enough to discipline the agencies; whether or not the complexity of the product is of significance in discussions of rating inflation; and finally if encouraging competition will in fact reduce conflicts of interests or instead increase ratings shopping. Through the analysis, we find that when large fractions of the rating agencies' revenues comes from rating complex products reputational concerns are not powerful enough to discipline the ratings agencies. Introducing competition, given that a certain amount the investors are naïve, will only increase issuers' options for ratings shopping. Therefore encouraging competition will probably not be a preferable solution to the ratings industry's problems. Furthermore we find that when the rated products are sufficiently complex, the issuer's incentive to shop for ratings is strong. Therefore an increase in complexity could induce a systematic bias in disclosed ratings, even when the agencies report truthfully. Combining the analysis and the results, this leads to one clear conclusion the credit rating industry needs regulation. We therefore discuss different possible policy recommendations, finding that a platform-pays model might be a sustainable solution.
|Educations||MSc in Mathematics , (Graduate Programme) Final Thesis|
|Number of pages||79|