Dealing with the conflicts of interest of credit rating agencies: a balanced cure for the disease

Abstract

Key points: The credit rating industry has long been plagued by acute conflicts of interest, which has led to a paramount level of rating inflation and the catastrophic failure of credit rating agencies (CRAs) in their roles as financial informational intermediaries during the Financial Crisis 2007–2008. The ‘issuer-pay’ business model is the root cause of this problem, although this remuneration model was classed as one of the most significant innovations of the credit rating industry for enhancing the industry’s sustainability and competitiveness in modern times. EU law is more effective and multifaceted with a focus on dealing with the ‘disease’ with a balanced cure while avoiding the overhaul of the ‘issuer-pay’ business model. The shareholding limitation rules, the mandatory contract rotation rule and the double rating rule should be feasible solutions in reducing conflicts of interest as well as improving competition, industry diversity and the rating quality of CRAs. The US legal reforms are partially successful, although gaps still exist because the SEC failed to improve the ‘issuer-pay’ model and other existing provisions are relatively weak. The ineffectiveness of the US law has a detrimental effect on the international rating industry because the most influential CRAs are subject to US law. This article proposes that the US regulators should press on with more regulatory effort to adopt the Franken Amendment/Random Selection Model with further refinements. Since the SEC showed little intention to adopt this model, the EU multifaceted model, together with several additional improvements, can provide a more effective solution.