Academics Caution About Increased Rating Agency Competition

In the wake of the mortgage-backed securities debacle and other questionable business practices, regulators in the U.S. and particularly Europe are urging that the “big three” rating agencies face increased competition to drive better quality ratings. However, Bo Becker of Harvard Business School and Todd Milbourn from Washington University, warn that increased competition may not be a solution.

Analyzing Moody’s and Standard & Poor’s reaction to the rapid growth of the then-upstart Fitch in the early 1990s, the authors explain in Financial Times that, “The evidence we uncover appears unequivocally consistent with lower ratings quality as competition increased.” Specifically, as Fitch’s market share grew, the accuracy (measured as the correlation between ratings and bond yields) of a rating fell about one-third and the predictive power of default fell by two thirds.

The authors hypothesize that “…competition most likely weakens reputational incentives for providing quality in the rating industry, and thereby undermines quality. The reputational mechanism appears to work best at modest levels of competition.”

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