Large credit rating agencies (RAs), such as S&P, have come under increasing criticism in recent years for a number of reasons. First, the RAs maintain close relationships with the management of the companies they rate. These connections are characterized by frequent meetings, during which the RAs provide advice on actions companies should take to maintain current ratings. This practice fosters a familial atmosphere that interferes with independent, unbiased rating judgments. Furthermore, because the RAs are paid by the companies they rate, rather than the investors they are meant to protect, a clear conflict of interest exists.
Second, because the rating business is reputation based (why pay attention to a rating that is not recognized by others?), barriers to market entry are high and RAs are oligopolists (an oligopoly is a market dominated by just a few sellers). Thus, the RAs are somewhat immune to forces that apply to competitive markets and, to an extent, can set their rules.
Finally, in many instances, the debt markets (through lower bond prices) have recognized a company’s deteriorating the credit quality many months before a rating downgrade occurred. This fact has led many observers to suggest that, rather than rely on ratings, investors and regulators should use credit spreads to make judgments about credit risk. (Credit spreads reflect the difference in yields between interest rates on “safe” debt, such as Treasury securities, and rates on risky debt such as B-rated bonds.)
What do you think? To what extent are credit ratings valid? Do the criticisms of RAs have merit? Can the current credit rating system be improved? If so, how?
1) make it simple as you can.
2) USE YOUR OWN WORDS.
3) And respond to this post with (3-5 sentences):
Failure to do valid credit ratings are what caused the financial crisis of 2008 because of the failure to acknowledge and warn investors of the risks in the mortgage ratings. Although policy makers have worked to improve the credit rating system since the collapse, I think their is still room for improvement in this area. The improvements made since then still seem to be far from transparent and an unsound fix to the past problem. I don’t think that just randomizing credit ratings and changing private ratings to public ratings is what is truly going to fix the flaws in the system. I think something that could fix the issue is to have a universal rating system that is public and and a more structured scale. Benchmarks of ratings would allow to catch issues early and not allow them to continue rather than just going and going without checking on how soundly and smoothly the system is going. The other obvious way to help fix the issues is to be clear in warning of true risk associated with the investment to the investors.