Who Funds Credit Rating Agencies?

Credit rating agencies (CRAs) play a crucial role in the global financial system, assessing the creditworthiness of borrowers, be they corporations, sovereign nations, or issuers of structured finance products. Their ratings influence investment decisions and the cost of borrowing, making their independence and objectivity paramount. However, the funding model of these agencies has long been a subject of scrutiny and debate, raising concerns about potential conflicts of interest.

The primary funding model for the major CRAs, such as Moody's, Standard & Poor's (S&P), and Fitch Ratings, is the issuer-pays model. This means that the entities being rated, rather than investors, pay the agencies for their ratings. This model emerged prominently in the 1970s and 1980s, replacing a prior model where investors typically subscribed to rating services.

Under the issuer-pays system, companies seeking to issue bonds or other debt instruments approach CRAs and request a credit rating. The agencies then conduct their assessment and assign a rating, for which they charge a fee. This fee can vary significantly depending on the complexity of the security being rated, the size of the issuance, and the reputation of the issuer. Larger and more intricate issuances, such as structured finance products like mortgage-backed securities, often command higher fees.

The inherent conflict of interest in the issuer-pays model is readily apparent. Since CRAs are paid by the entities they are rating, there's a potential incentive for agencies to provide more favorable ratings to maintain or attract business. If an agency is perceived as being too critical, issuers might simply choose to go to a different agency perceived as more lenient. This "rating shopping" can lead to a race to the bottom, where agencies compete to provide the most generous ratings, ultimately undermining the accuracy and reliability of the ratings themselves.

Following the 2008 financial crisis, which was partially attributed to overly optimistic ratings of complex structured finance products, regulators implemented reforms aimed at mitigating these conflicts of interest. The Dodd-Frank Act in the United States, for example, introduced measures designed to increase CRA accountability and transparency. These included enhanced disclosure requirements, potential liability for inaccurate ratings, and the establishment of the Office of Credit Ratings within the Securities and Exchange Commission (SEC) to oversee CRAs.

Despite these reforms, the issuer-pays model remains the dominant funding mechanism. Alternative funding models have been proposed, such as a system where a central authority or investor consortium selects and pays the CRAs. However, these alternatives have faced challenges in terms of implementation and acceptance within the financial industry. While improvements have been made in transparency and regulatory oversight, the core concern regarding the potential for conflicts of interest within the issuer-pays model continues to be a topic of ongoing discussion and debate.