Article: Conflicts of Interest in the Credit Rating Industry After Dodd-Frank: Continued Business As Usual?

7 Va. L. & Bus. Rev. 1, Spring 2012

Authors: Nan S. Ellis, Lisa M. Fairchild and Frank D'Souza

Excerpt

I. Introduction
 
SINCE their inception, credit rating agencies (CRAs) have been important to the efficient functioning of debt markets. Their assessments of the creditworthiness of issuers are captured by the ratings assigned and act as certification of an issuer's capacity and willingness to repay its debt obligations. Hence, investors with different risk preferences use ratings to determine the appropriateness of debt instruments for their portfolios. For institutional investors, such as commercial banks, there are regulatory requirements stipulating that only debt with "investment grade" ratings can be purchased for the banks' investment portfolios. It is, therefore, crucial that the ratings assigned are accurate and are provided by impartial third parties.

CRAs assign credit ratings based on information provided to them by the issuers. Their analysts then use sophisticated statistical models that consider the issuer provided information along with information from other sources, such as economic data, to determine an appropriate rating for the issuer. CRAs charge the debt issuers a fee for this service and make the ratings available to investors at no charge. This so-called issuer-pays business model has allowed CRAs to generate significant revenues, has allowed CRAs to grow in size and influence in the financial markets, and has significantly called into question their impartiality in assigning these ratings. It has been argued that the conflicts of interest inherent in this model affect the accuracy of the credit ratings assigned. Debate surrounding these questions has grown in intensity in the aftermath of ...

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