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Journal of Business Ethics

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01-12-2012

The Ethics of Credit Rating Agencies: What Happened and the Way Forward

Authors: Steven Scalet, Thomas F. Kelly

Published in: Journal of Business Ethics | Issue 4/2012

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Abstract

During the short span of a few months in 2008, 14 trillion dollars of highly rated bonds fell into junk status, surprising the global financial system and accelerating an economic decline. The result was the worst fracture of the US financial system since the Great Depression. Credit rating agencies (CRAs) in particular have come under intense scrutiny as a result of this latest disaster, both domestically and internationally, including many congressional inquiries and government investigations. Most of the public and scholarly discussions about CRAs focus on reforming the financial system so that the crisis of the magnitude of the 2008 disaster will not happen again. An important overtone of industry criticisms includes a sense of ethical impropriety on the part of CRAs and ethical uncertainty about the institutional mechanisms that are currently in place. Rarely, however, are the ethics of the industry the explicit subject of analysis. In this article, we discuss the lessons from the policy debates and recent legislation to develop an account of the ethics of the CRA industry.

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http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ahT21h2yXkqQ.

As stated on its website: “The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” And: “The SEC oversees the key participants in the securities world, including securities exchanges, securities brokers and dealers, investment advisors, and mutual funds. Here the SEC is concerned primarily with promoting the disclosure of important market-related information, maintaining fair dealing, and protecting against fraud” (http://sec.gov/about/whatwedo.shtml).

For more on the history of CRAs, see the writings of Duff and Einig (2009), Langohr and Langohr (2008), Sylla (2002), and Strier (2008).

Strier emphasizes that CRAs performed very poorly with respect to the complex structured securities that propelled the financial crisis. Not all agree about how to assess the significance of this data. Some scholars focus historically on longer-term trends to argue that credit ratings are generally quite accurate (See, for example, Damodaran, Aswath, http://people.stern.nyu.edu/ealtman/AboutCorporateDefaultRates.pdf). One could also argue that an unforeseen recession significantly explains the most recent defaults, and so these defaults should not implicate the rating performance of the CRAs. On the other hand, some commentators argue that CRAs lacked competency to rate those particular complex securities. We consider this “lack of competency” argument below, a position that could find additional support depending on whether the data shows a disparity between the ratings accuracy of the complex structured securities compared to the ratings on other securities. We thank an anonymous reviewer for comments on these issues.

For more information, see the official website of the European Commission, especially http://europa.eu/rapid/pressReleasesAction.do?reference=IP/09/629&format=HTML&aged=0&language=EN&guiLanguage=en.

To add to the discussion above about conflicts of interest, CRAs also face potential conflicts when they rate sovereign nations. These are the same nations that regulate CRAs. How will rating decisions over time about sovereign debt affect government’s decisions about oversight and control of CRAs? The conflict will always be present so long as the industry is organized as private firms subject to government authority.

We thank an anonymous reviewer for comments on these points.

The economics literature on two-sided markets, also called two-sided networks, is relevant to analyzing the economics of the CRA industry. A two-sided market occurs when some platform brings together two end-users and tries to charge one or both sides to create a profitable network. For example, newspapers bring together viewers and advertisers, and they may charge either or both users. CRAs bring together those who issue securities and those who buy securities. For a discussion of the economics of two-sided markets, see Rochet and Tirole (2006).

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Title: The Ethics of Credit Rating Agencies: What Happened and the Way Forward
Authors: Steven Scalet
Thomas F. Kelly
Publication date: 01-12-2012
Publisher: Springer Netherlands
Published in: Journal of Business Ethics / Issue 4/2012
Print ISSN: 0167-4544
Electronic ISSN: 1573-0697
DOI: https://doi.org/10.1007/s10551-012-1212-y

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