Evaluating Proposed Remedies for Credit Rating Agency Failures : Improving Independence and Justifying Departures from Quantitative Credit Rating Models

The overly optimistic debt ratings provided by credit rating agencies (CRAs) and the lack of transparency about the rating process have been criticized by regulators and pundits for exacerbating the financial crisis. We conduct a mixed-design experiment exploring how two proposals advanced by lawmakers affect the behavior of credit rating analysts. Using data taken from personal lending site Prosper.com, we examine whether (a) the requirement to justify departures from a quantitative model, and (b) conflicts of interests stemming from who pays the analysts affect rating characteristics. We then examine how justifying departures in turn influences the conflicts of interest faced by credit raters. We find that justifying departures reduces the likelihood that credit raters deviate from a quantitative model. Furthermore, credit raters who are not required to justify departures from the model tend to depart from the model in a direction that benefits the borrower, but only in the “borrower pays” condition. Additionally, credit raters facing conflict of interest appear to behave strategically and are less willing to lend their own money to borrowers, even if these credit raters assign more favorable ratings to these same borrowers. This study complements the existing archival literature on credit rating agencies and the conflicts of interest facing these agencies. Results of this study may inform regulators regarding the effectiveness of the different proposals on CRA reform