Market failure or regulatory failure? The paradoxical position of credit ratings agencies

It is commonly considered that credit rating agencies (CRAs) play a central role in financial markets because of their reputational capital derived from evaluating the solvency of firms and creditworthiness of debt securities. Although the role played by CRAs is deemed valuable, their involvement in debt securities’ regulation has generated a demand for ratings that is associated with the need to comply with such regulation and not necessarily with the quality of ratings. For this reason, the regulatory use of ratings may give rise to a systemic risk: namely the risk of market and regulatory failures. On the one hand, market discipline has not succeeded in reducing its overreliance on ratings’ activities. On the other hand, regulators have largely failed to address the conflicts of interest besetting rating agencies. This article argues that CRAs should be regulated having due regard to their potential systemic threat and should be subject to professional standards similar to those applicable to other information intermediaries such as auditors and financial analysts.