Conflicts of interest
196. A final substantive area of concern with respect
to credit rating agencies that emerged during our inquiry is the
charge that the credit rating agencies are "conflicted".
The charge that credit rating agencies are "conflicted"
was made for two reasons. First, because the credit rating agencies
are paid by the sellers rather than the buyers of the products
they rate, which could influence the ratings they provide. The
second concern is that the credit rating agencies provide additional
services to the firms whose products they rate.
197. Michel Madelain from Moody's confirmed that
in the ratings industry "fees are paid by the issuers of
Mr Sants told us that the payment model used by credit rating
agencies did result in a "conflict" and that it was
necessary to ascertain what consequences flowed from such "conflicts".
Mr Madelain also acknowledged that the pay model used in the ratings
business did create a potential conflict of interest but, along
with other representatives from the credit rating agencies, believed
that "conflicts" were well-managed. Mr Madelain said:
what we do believe is that we do manage that conflict
effectively, as has been demonstrated by our track record in this
area and also I think, as we have stated many times, by the importance
of our reputation for the viability of the services we provide.
198. Both Mr Madelain and Mr Bell stressed that reputational
integrity was of crucial importance to the agencies, citing previous
investigations of ratings agencies by the Committee of European
Securities and the European Parliament which the agencies told
us, "reached the conclusion that our conflicts of interest
did not impact on the ratings we gave".
Sir John Gieve, when asked about possible "collusion"
between the banks and the credit rating agencies, told us that
"I think the ratings agencies' response to that is that their
reputation and their future business depends on producing ratings
which stand up in practice".
Professor Buiter told us that the credit rating agencies were
"subject to multiple potential conflicts of interest".
He acknowledged that reputational considerations did help "mitigate
the conflict of interest problem", but stressed that reputation
alone could never eliminate the problem because:
even if the ratings agencies expect to be around
for a long time (a necessary condition for reputation to act as
a constraint on opportunistic and inappropriate behaviour) individual
employees of ratings agencies can be here today, gone tomorrow.
A person's reputation follows him/her but imperfectly. Reputational
considerations are therefore not a fully effective shield against
conflict of interest materialising. 
199. The second "conflict of interest"
highlighted by witnesses was that the credit rating agencies provide
additional services to the firms whose products they rate. This
is a potential concern if these additional services are used to
assist issuers of securities in achieving investment grades for
their products. Mr Pitt-Watson emphasised his concern that credit
rating agencies "would provide additional services to the
company of all sorts".
Professor Buiter also argued that credit rating agencies were
subject to potential conflicts of interest on these grounds:
They are multi-product firms that sell advisory and
consulting services to the same clients to whom they sell ratings.
This can include selling advice to a client on how to structure
a security so as to obtain the best rating and subsequently rating
the security designed according to these specifications. 
200. We asked representatives from the credit rating
agencies whether they provided such advisory functions to clients.
Representatives from the credit rating agencies denied that they
provided technical assistance and advice on how to design structures
to attract the best possible rating.
They stressed that different parts of the business provided such
assistance and advice and were separated from the rating side
of the business. Mr Drevon told us that "we do provide some
additional tools to the market, but those are done separately,
they will be done separately from the ratings agency".
Barry Hancock said Standard and Poor's adopted a similar approach,
whilst Paul Taylor from Fitch informed us that Fitch Ratings did
not provide these services, although he added that "we have
a sister company, which is a completely different company".
When questioned as to whether there were Chinese walls between
sister organisations, Mr Taylor replied, repeating his earlier
answer, that it is a different company which provided those services.
Mr Madelain stressed that such services "are unrelated to
Professor Buiter disagreed, telling us that "even the sale
of other products and services that are not inherently conflicted
with the rating process is undesirable, because there is an incentive
to bias ratings in exchange for more business".
201. It is incumbent
upon the credit rating agencies to provide further reassurance
that conflicts do not exist between their advisory and rating
functions. If the credit rating agencies fail to demonstrate that
Chinese walls alone are a sufficient safeguard then it may be
necessary to look at alternative approaches to tackling this problem.
202. The Bank of England's proposals discussed in
the previous chapter aim to facilitate a more sophisticated use
of credit ratings by investors. They do not, however, address
the "conflicts of interest" issue discussed above. Witnesses
to our inquiry were clear that further reforms in the way credit
ratings agencies operated were necessary to help tackle the issue.
Angela knight believed it was important to tackle to address the
"conflict of interest" issue: "I think there is
something about the separation of the provision of ratings from
the financing of the agencies that is important" 
The Investment Management Association did not favour a regulatory
approach to tackling "conflicts of interest", but instead
argued that the credit rating agencies "should put in place
policies and procedures to identify, manage and, where incapable
of being managed out, disclose conflicts inherent in their individual
Professor Buiter's solution to the "conflict of interest"
resulting from the provision of additional services was for the
ratings agencies to:
become "monolines", basically agencies
just doing one activity, just doing ratings. You cannot manage
the potential conflict of interest involved in advising a client
on how to design a structured financial product to get the best
possible credit rating and then rate that same product. That is
going to create a conflict of interest so it should just not be
possible to do that; you rate and that is it.
Professor Wood agreed with Professor Buiter's proposal
that the agencies should become monolines, telling us that it
was surprising that "the agencies have not grasped that for
themselves and set up separate ratings agencies because these
would attract customers".
203. Lord Aldington, whilst acknowledging that potential
"conflicts of interest" did exist under the issuer pays
model, pointed out that:
this debate about ratings agencies has been going
on for years and years and nobody has yet found a better solution
as to how to pay or compensate the ratings agencies.
Mr Sants expressed similar concerns, telling us that
it is not obvious that without that issuer pays model the credit
ratings agencies "would be able to continue to thrive commercially
Sir John Gieve said that he would welcome a situation where investors
could sponsor a rating agency where the ratings agencies "were
being paid by the people they were supplying the service to".
Sir John acknowledged that an investor-pays model had thus far
"not proved possible as a business model", but went
on to tell us that he "would not be surprised if some of
the investment bodies consider that again".
Professor Buiter argued that payment by the issuer needed to end
and suggested a number of ways forward:
Payment by the buyer (the investors) is desirable
but subject to a 'collective action' or 'free rider' problem.
One solution would be to have the ratings paid for by a representative
body for the (corporate) investor side of the market. This could
be financed through a levy on the individual firms in the industry.
Paying the levy could be made mandatory for all firms in a regulated
industry. Conceivably, the security issuers could also be asked
to contribute. Conflict of interest is avoided as long as no individual
issuer pays for his own ratings. This would leave some free rider
problems, but should get the rating process off the ground. I
don't think it would be necessary (or even make sense) to socialise
the rating process, say by creating a state-financed (or even
industry-financed) body with official powers to provide the ratings.
are deeply concerned about the conflicts of interest faced by
the credit rating agencies and agree with Professor Buiter that
the credit rating agencies are subject to multiple potential conflicts
of interest. These conflicts of interest have undermined investor
as well as public confidence in the rating agencies and must be
tackled as a matter of urgency. Without reform the credit rating
agencies will be unable to regain public trust and confidence.
It is therefore incumbent upon the ratings agencies as a matter
of urgency to demonstrate that they can effectively manage and
be seen openly and transparently to manage the conflicts of interest
in their business model out of the system. To this end, the credit
rating agencies must put in place policies and procedures to identify,
manage and, where incapable of being managed out, disclose conflicts
inherent in their individual business models If they are unable
to do this then new regulation will have to be seriously considered.
Buiter and Sir John Gieve both suggested to us that the conflict
of interest problem could be tackled if investors paid for ratings.
However, this may merely serve to encourage conflicts in the opposite
direction. For example, if investors paid for ratings they may
have an incentive to bargain down ratings so as to maximise their
rate of return. This suggests that it may prove difficult to remove
such conflicts of interest simply through moving to an investor
pays model and that the priority should be to ensure that a robust
framework for managing conflicts of interest is put in place.
Increasing competition within
the ratings industry
206. The issue of increasing competition in the ratings
industry was raised by a number of witnesses to our inquiry, including
Professor Buiter, who told us that "competition in the rating
process is desirable" and that "the current triopoly
is unlikely to be optimal". Professor Buiter argued that
entry for new firms into the industry would become easier if the
ratings agencies became single-product firms, although he cautioned
that, for new firms, "establishing a reputation will inevitably
The Investment Management Association concurred that greater competition
was desirable, telling us some of the possible benefits: "the
IMA remains of the view that more competition in the ratings process
will encourage a higher level of analytical input and thereby
improve the quality of ratings overall".
The IMA cautioned, however, that registration or regulation of
ratings agencies could have the unintended consequence of raising
barriers to entry to the industry.
Interestingly, representatives of the credit ratings agencies
also agreed that an increase in the number of ratings agencies
would be desirable.
207. We are
not convinced that the credit rating agency market is sufficiently
competitive or efficient. At present the market is dominated by
the two big US ratings agencies, Moody's and Standard & Poor's
plus the European agency, Fitch. We therefore call upon competition
authorities to examine what barriers to entry have prevented greater
competition in the industry and how competition within the industry
could be encouraged.
208. As we noted in chapter two, the monoline insurers
have also played an important role in securitised markets. They
provided third-party insurance or other financial guarantees to
protect investors in securitised markets against loss. The continued
deterioration in structured credit markets and, in particular,
in securities related to US sub-prime mortgages has increased
the potential for higher than expected claims to emerge. This
has prompted pressure for credit rating downgrades of monoline
insurers. Downgrading of the ratings of the monolines can occur
when claims reduces a monoline's capital buffer to below the minimum
required to maintain its rating. For example, one of the largest
monoline insurers, Ambac Financial Group, announced a fourth quarter
2007 net loss of $3.255 billion and has since been downgraded
by Fitch ratings.
Other large monoline insurers are also at risk of downgrades.
As a result, the monoline insurers have been forced to seek extra
capital to ensure that they can meet their obligations amidst
the risk that otherwise they could lose their triple A rating.
The consequences of a monoline downgrading would have wider market
consequences, as the FSA explained in their January 2008 Financial
If a monoline is downgraded, the ratings of the securities
insured by the monoline would also be at significant risk of downgrade.
This could have wider market consequences and potentially result
in the reduction in the credit quality of portfolios, and where
portfolios are required to have minimum credit quality, forced
We expect to continue to monitor
the role of monoline insurers and the risks associated with the
problems they face.
271 Q 297 Back
Q 999 Back
Q 992 Back
Q 991 Back
Q 96 Back
Ev 313 Back
Q 1000 Back
IMF, Global Financial Stability Report, October 2007, p
Q 969 Back
Q 1487 Back
Q 963 Back
Q 983 Back
Q 95 Back
Ev 313 Back
Ev 313 Back
Q 1385 Back
Ev 313 Back
Qq 952-957 Back
Q 958 Back
Qq 959-960 Back
Q 961 Back
Q 962 Back
Ev 314 Back
Q 1585 Back
Ev 291 Back
Q 930 Back
Q 931 Back
Q 1249-1251 Back
Q 1487 Back
Q 1700 Back
Ev 313 Back
Ev 314 Back
Ev 291 Back
Ev 291 Back
Q 1028 Back
Ambac Financial Group, press release, 22 January 2008 Back
, FSA, Financial Risk Outlook, January 2008, p 58 Back