In our recent ECGI working paper, A Strict Liability Regime for Rating Agencies, we study how to induce Credit Rating Agencies (CRAs) to produce ratings as accurate as the available forecasting technology allows.
Referring to CRAs, Paul Krugman wrote that: “It was a system that looked dignified and respectable on the surface. Yet it produced huge conflicts of interest. Issuers of debt […] could choose among several rating agencies. So they could direct their business to whichever agency was most likely to give a favorable verdict, and threaten to pull business from an agency that tried too hard to do its job.”
However, the conflicts of interest stemming from the issuer-pays model and rating shopping by issuers are not sufficient to explain rating inflation. Because ratings are valuable only as far as they are considered informative by investors, in a well-functioning market, reputational sanctions should prevent rating inflation.