Thursday, July 30, 2009

Increasing Competition Won’t Stop Rating Shopping

Posted on RiskCenter by Laura Veldkamp:

As proposals circulate on how to fix the credit rating agency problem, new research from NYU Stern suggests that increased competition and more regulation aren’t the answer. Solutions, say two economics professors, lie with getting credit rating agencies to adjust for the bias that results from ratings shopping.

Economics professors Vasiliki Skreta and Laura Veldkamp find that an increased complexity of assets drives companies to shop around for, and to publicize, the best ratings. Based on their research, the authors propose:

  • Reformulate ratings so that they explicitly account for asset complexity and the resulting model uncertainty.
  • Adopt policies that encourage unsolicited ratings.
  • Repeal the first amendment protection that rating agencies currently use to hold them more accountable. This would encourage rating agencies to be more conservative in their ratings.

“Rating agency conflicts of interest and the possibility for ratings shopping have existed since the inception of the issuer-initiated ratings system in the 1970s. Yet, ratings were remarkably accurate for decades. We argue that the change in the nature of credit products, specifically their greater complexity, triggered ratings shopping and bias. The emergence of ratings shopping, in turn, created incentives for companies to build even more complex assets,” said Professor Veldkamp. “And if ratings shopping is the problem, legislation to increase competition in the ratings market could worsen ratings bias, because more rating agencies offer shoppers a broader menu of ratings to choose from.”

To read the full paper, visit: http://pages.stern.nyu.edu/~lveldkam/

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