My latest paper* focuses on the difficulties that rating agencies face in setting a credit score that accurately reflects the credit quality of a borrower, but also takes into account the effect that score will have on the borrower’s credit quality in the future. When a rating agency cuts a given company’s credit rating, investor confidence in that company’s ability to meet its debt obligations is undermined, making it very difficult for the company to raise cash. The downgrade often becomes a self-fulfilling prophecy.
In my paper I talk about the ideal accurate credit rating environment. It’s important to note that there may be several possible ratings that are accurate for a particular firm or country at any point in time, but some of these ratings lead to more distress than others. I believe rating agencies ought to be careful to select the best rating: one that provides an accurate portrayal of the company’s credit worthiness, but also takes into account the continued existence of the company in question. These ratings – where the agencies have a small bias towards the ultimate survival of the companies they evaluate – allow the companies to borrow money at a lower interest rate and therefore improve their chances of withstanding any financial shocks that may arise.
I worry that an alternative ratings environment – one where agencies are not concerned with the survival of the firms they rate – incites a dangerous race to downgrade. Rating agencies want to be seen as first-movers in cutting a credit score lest they be accused of dropping the ball. But the competition to be the “first-to-downgrade” only heightens the frequency of defaults. And the more bankruptcies, the greater stress on the financial system.
The other troubling element of ratings environment like this one is the use of stress tests. Stress tests are an evaluation method that involves a rating agency assessing credit worthiness by posing different worst-case economic scenarios to determine the vulnerability of the company. In these stress tests, companies need to be able to survive stress-case scenarios in which rating triggers are set off or else they are given an automatic downgrade. This downgrade creates distress in the system.
According to my analysis, however, failure in a stress test does not necessarily imply that the company should be downgraded. A given company could fail when triggers are set off in a model, but still be able to survive real-world economic strain if no downgrade occurs. It’s clear to me that stress tests are not the best judge of a company’s credit worthiness, and in fact may cause unnecessary distress in the system.
The optimal credit rating situation can be achieved with a rating agency that is concerned about the survival of the company it’s assessing.
How can we accomplish this? Based on my research, I believe that the best way to implement this kind of rating environment is through the issuer-pay model, where companies being rated pay a small fee to the rating agency in exchange for its services. This would be a nominal, ongoing charge until the company being evaluated defaults.
The basis of this model is that the rating agency cares first and foremost about accuracy and its reputation in the industry, and second about minimizing the probability of defaults of the companies it rates.
The issuer-pay model is close to how the industry is currently structured, and yet the fact that rating agencies are paid by the firms they rate has received a great deal of criticism. The concern is that this practice may induce bias. While this is certainly legitimate, my research suggests that these small fees do not introduce significant prejudices, and in fact do more good than harm because they subtly encourage the credit rating agencies to be mindful of the survivability of the companies they evaluate.
For a rating agency, potential reputational losses from setting inaccurate ratings are likely to be much more important than the fees they receive from any individual company. Thomas McGuire, former VP of Moody’s, said it best: “what’s driving us is primarily the issue of preserving our track record. That’s our bread and butter.”
* Feedback Effects of Credit Ratings by Gustavo Manso, MIT Sloan School of Management; forthcoming
Gustavo Manso is Maurice F. Strong Career Development Professor of Management; Associate Professor of Finance
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