William & Mary Business Law Review


Credit rating agencies have for years averred that they would never intentionally issue or maintain inaccurate ratings due to the damage their reputation, and therefore their business, would suffer as a result. The reputation of credit rating agencies perhaps never suffered more than when thousands of structured debt securities proved to hold inflated ratings during the run-up to the credit crisis. Yet credit rating agencies remain as ingrained as ever in the global financial system. What is more, congressional testimony shows that credit rating agencies had the ability to rate more accurately, but intentionally failed to do so. Therefore, credit rating agencies inwardly believed that their reputations with investors were not nearly as valuable as they outwardly claimed. Their ability to thrive while their reputations languish proves that they were right.

Reputation mechanisms theoretically operate in the credit rating industry to solve problems of information asymmetry. Whereas investors cannot trust issuers to truthfully convey their own credit risk, a credit rating agency must guard its reputation and the related promise of future business due to the comparatively small fee it earns for each opinion it provides. The actual credit rating industry, however, differs from the model in several ways that have the potential to undermine reputational incentives. Regulations tied to credit ratings give Nationally Recognized Statistically Rating Organizations (NRSROs) the power to sell cost-reducing and demand-increasing regulatory compliance to issuers. Further, regulatory and market factors may increase the short-term profitability of falsifying ratings or diminish the long-term profitability of reputation-building.

The current statutory and regulatory regime governing credit rating agencies ignores these barriers to accuracy. The Credit Rating Agency Reform Act of 2006 (CRARA) and the SEC regulations thereunder instead assume that making the credit rating industry more transparent, more competitive, and less conflicted will restore the quality of credit ratings. By providing investors with more information and more choices, the CRARA largely aims to enable investors to accurately assess agencies' reputations and hold them accountable for issuing or maintaining inaccurate ratings. Despite the manifest failings of credit rating agencies since 2006 and the unaddressed theoretical barriers to an effective reputation mechanism in the credit rating industry, the Treasury Department recently endorsed continuing to regulate credit rating agencies under the current system.

In place of these measures, successful reform efforts must either restore the role of reputation in the credit rating industry or obviate the need for it. Proposals in the latter category face difficulties that make them either impractical or ineffective. Dismantling the NRSRO superstructure, meanwhile, would remove the principal barrier to reputation economics. To fill the void left by ending ratings-based regulation, regulated investors would be given primary responsibility to certify risk, but would also be allowed to rely on credit spreads as a safe harbor. Such a solution would both produce accurate ratings and protect investors without overburdening regulated institutions.