Question

a) Explain the possible reasons for causing such conflicts and the circumstances in that conflicts of interest for CRAs are most likely to happen.

b) If a conflict of interest for CRAs exists in the financial market, provide some possible ways to mitigate such conflicts.

Answer 1

a.     Explain the possible reasons for causing such conflicts and the circumstances in that conflicts of interest for CRAs are most likely to happen.

Rating agencies are primarily compensated by the issuers of the securities they grade. These businesses or their securities benefit from good (high) ratings. As a result, the remuneration structure creates a conflict of interest between rating producers (agencies) and rating consumers (such as investors). When purchasing debt instruments, investors may run afoul of credit rating agencies (CRA) (Nwogugu, 2016). Conflicts of interest in the securities of rated companies can occur. This kind of conflict arises when personnel of a rating agency holds securities or money market instruments issued by or owed to issuers or obligors subject to the rating agency's credit ratings.

The worry is that permitting rating agency employees to hold stocks may result in instances where an incorrect credit rating is given to benefit such employees' trading positions. Even if the holders of securities are not actively engaged in the grading process, this conflict persists. For instance, a credit analyst may be swayed by a coworker whose job function has nothing to do with rating but who owns assets the analyst assesses. The analyst may be tempted to provide an excessively favorable evaluation to increase the value of his colleague's assets.

b.     If a conflict of interest for CRAs exists in the financial market, provide some possible ways to mitigate such conflicts.

Various measures may be taken to minimize investors' conflict of interest with CRAs. Transparency about possible conflicts of interest inside rating agencies should be improved (Lipszyc, 2017). Additionally, agencies should issue standards of behavior in collaboration with regulators. Further, monitoring of actions that show indications of conflict of interest should be strengthened.

 References

Lipszyc, D. (2017). Credit Rating Agencies and Conflicts of Interest: Comparative Study of the Post-Credit Crisis Regulatory Reforms. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.1919960

Nwogugu, M. (2016). Credit Rating Agencies. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.1761406

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Rating agencies are primarily compensated by the issuers of the securities they grade.