This is the abstract of an article regarding the raison d'etre of credit rating agencies in The Journal of International Legal Affairs, Kyung Hee University, published on February 27, 2009.
These days in the worldwide economic turmoil, credit rating agencies are to blame owing to their inaccurate and flawed ratings of structured products like MBS, CDO, etc.
As Financial Times admitted in its editorial "Quo vaditis, raters?" of February 22, 2009, we cannot live with their current practices, but nor can we live without them;
their function - assessing the risk of securities - is indispensable.
Reform is essential.
Credit ratings agencies (CRAs) are paid by issuers of securities and not by those who invest in them. They have traded their independence to chase the lucrative business of rating asset-backed securities which came to market in the last decade.
Regulators must put an end to the noxious combination of privileged status and conflicts of interest.
Reducing barriers to entry would be healthy: competition can lead to improved methodologies.
If barriers are too low, however, issuers will go rating-shopping to the laxest rater.
A regulatory stamp of approval must be required that guarantees independence and competence, not entrenched privilege.
No business should be done with issuers of securities that need ratings. Conflicts of interest cannot be removed if CRAs are paid by issuers.
But the core problem lies in the nature of risk assessment itself.
CRAs' attempt to capture credit risk by one simple measure just led investment banks to package securities so as to obtain triple-A ratings.
This potential for systemic risk in the rating regime itself is one problem that must be addressed.
CRAs and investors must employ more nuanced measures of risk.
CRAs say investors must ultimately take responsibility for their judgments.
That is no reason not to hold CRAs more responsible for theirs.
Against these backdrops, Korean Financial Regulators (FSS) initiated to include the reinforced regulatory scheme into the newly amended Credit Information Act
- a tough standard for internal control, the violation of which lead to the imposing of administrative fine on CRAs.
The mandatory separation of rating and advisory services, and prohibition of conflicts of interest are quite right.
However, addressing unfair practices and sophisticated methodologies in the new act went too far.
To our disappointment, it could invoke unexpected flux of lawsuits against CRAs by investors at home and abroad.