Question

Bond rating agencies have invested significant sums of money in an effort to determine which quantitative and non quantitative factors best predict bond defaults. Furthermore, some of the raters invest time and money to meet privately with corporate personnel to get non public information that is used in assigning the issue’s bond rating. In order to recoup those costs, some bond rating agencies have tied their ratings to the purchase of additional services. Discussion Questions Do you think that this is an acceptable practice? Defend your position. What is the impact of this practice on the capital markets? What other means can rating agencies use to raise revenue to fund their operations?

Answer 1

No, this is not an acceptable practice because the rating agencies get access to non-public information. This skews the information advantage to the rating agencies, and deprives investors and the general public from accessing material information which is made selectively available to rating agencies. Futhermore, tying ratings to the purchase of additional services is a clear conflict of interest. The rating agency must be independent and free of conflict.

The impact of this practice on capital markets is that the ratings issued may not be fully independent and fair. This distorts the credit rating and cost of capital for borrowers. The credit rating may be overstated for risky borrowers who purchase additional services from agencies , and understated for genuine borrowers who do not purchase additional services from agencies.

Rating agencies can tweak their revenue model to raise revenue from the users of these ratings. Instead of raising revenue only from those firms which are being rated, the users of ratings such as investors, analysts, investment bankers etc. can be charged for using the ratings.