“Overall, the rating bias distorts the financing costs of large banks and reinforces the creation of ‘too big to fail banks’ devoid of economic rationale,” the authors say.
In a third finding, the results revealed conflicts of interest between banks and agencies related to their other business relationships.
“The more a bank used a particular rating agency for rating its asset-backed securities at issuance, the more this agency rewarded the bank with a better bank credit rating,” the authors write, noting elsewhere in the paper that the rating process “is probably compromised by overlapping business interests between rating agencies and large banks.”
In light of these shortcomings, the authors suggest, investors should seek out alternative sources of credit rating information. A couple of recent studies have shown that corporate credit rating measures that are at least as accurate as those from agencies can be produced at no cost, using public information. The authors propose enhancing the scrutiny of large banks, and urging them to make more public disclosures. “Better public information and more bank reporting is the best strategy to reduce the exorbitant influence of rating agencies in the current financial system,” they say.
Finally, the authors note that the 2010 Dodd–Frank Act, which is designed to decrease regulators’ reliance on rating agencies, will most likely encourage the emergence of alternative rating agencies (including nonprofit or low-cost agencies) in the U.S. But elsewhere, that is less likely to happen. In most countries, the authors write, comprehensive data on banking results is kept from the public and even from many regulators.
Credit rating agencies assign better ratings to large banks, resulting in economically significant outcomes that help perpetuate the “too big to fail” phenomenon. This appears to be a result of potential conflicts of interest between the ratings agencies and the banks. Overall, the credit ratings assigned to banks have typically been poor indicators of whether they would default in the near future.