It works! Ratings improve as agencies compete

Since the dot-com collapse in the early 2000s – and with greater impetus after the 2007-09 financial crisis – policy-makers have come to think that credit ratings are deeply flawed. The response, however, has been somewhat tentative, since there's no easy solution to the conflicts of interest inherent in the business of hiring someone to say bad things about you in public. In the European Union, credit rating agencies now have to register and be regulated directly by the European Securities Market Authority, a new piece of the EU bureaucracy that replaced the talking-shop known as European Committee of Securities Regulators in January. In the US, the Dodd-Frank legislation last year marked the latest in a series of policy-led attempts to ease the conflicts through tighter regulation. The US is something of a special case, but it's also an interesting hot-house for experimentation. There, credit ratings have long been enshrined in regulation. Municipalities needing to issue bonds were required by law to get credit ratings from a handful of nationally recognised statistical rating organisations. Widening the circle of NRSROs was one of the first responses to the dot-com crisis. Taking away the requirement for ratings – and with it quasi-official status of the agencies – is underway now.

From the laboratory: This scope for experimentation means that we can model different approach. According to a paper from scholars at Baruch College in New York, competition can be a viable alternative to regulation. Competition improves the timeliness of bond downgrades and helps investors assess the risks associated with their investments. "For three distinct financial scenarios we find that when there are multiple bond rating agencies rating the same issue, rating agencies provide investors with more accurate and/or more timely information about the riskiness of the rated debt issue," the authors write. In the case of new bonds, they found that increased competition led to more accurate pricing at the time of issuance. When companies had to restate earnings and recognise bond defaults, competition led to the more timely recognition of both unintentional restatements and default. If the implication is that if greater regulation of ratings drives up the cost and retards competition, could we be headed in exactly the wrong direction?

Source document: A working paper with the snappy title "How Increased Competition Among Credit Rating Agencies Improves Investor Awareness of Initial Bond Ratings, Accounting Restatements, and Bankruptcy Predictions," by Anna Bergman Brown, Joseph Weintrop and Emanuel Zur of Baruch College of the City University of New York, is a 53-page pdf file.