Credit Rating Agencies: A Vestigial Organ in the Financial Organism? A Reconsideration of the Dynamic Effects of Competition on the Rating of Structured Securities

Erik Asbjørn Arvid & Jens C. C. Gjerrild

Student thesis: Master thesis

Abstract

This paper sets out to investigate the effects that competition among credit rating agencies has on their rating behavior with regards to assigning risk assessments to more complex, structured securities. More specifically, this study proposes that increased competition will cause inflation of the distribution of ratings. In addition, it is further believed that these effects from competition move in a circular motion, or “cycles of confidence”. A primary motivation for taking on this subject is the evident research gap within the empirically based study of rating behavior for structured securities. This is herein done from a constructed behavioral model from which hypotheses are derived, empirically reviewed and subsequently subjected to quantitative analysis in order to identify possible competition-related effects. The results of the analysis mainly provided support for the hypothesized notion that competition intensity has indeed had a strong impact on rating behavior, with the nature of the effects appearing to follow what resembles a cyclical motion. Finally, the findings of the analysis have been compared to related investigations in order to not only evaluate and assess the rating-related problems more closely, but also to further gauge the proposed solutions from other, earlier studies. The end result of this is a reconsideration of where the focus should be when trying to address the elucidated problem of imprecise credit ratings. Instead of focusing on either the applied rating models themselves or the related regulation, the results of this study imply that the root cause of the problem should lie with the raters’ business model itself. By redesigning this model to become investor-paid, as it was before 1974, incentives towards ensuring rating precision should become aligned. Yet, in order to attain a sustainable business model, inspiration must be sought in similar industries, to solve the challenges that initially triggered the change in the 1970’s. The resulting findings contribute to the existing literature within three distinct areas. First of all, the strong bond between increased competition and rating inflation has previously not been empirically documented for structured securities as it has here. Second, the empirically supported results from the study of investor behavior and rating reactivity has implied that credit ratings do not create much market impact, and thus hold little to no value for the issuers who are buying the rating service. Finally, this paper has pointed out a so far ignored area for academic scrutiny in the shape of information asymmetries in the issuerrater relationship; it is believed that further studies within this field will shed more light on the true workings of the credit rating industry.

EducationsMSc in Finance and Strategic Management, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2013
Number of pages146