A credit rating is an opinion on how creditworthy a borrower is. Five Bank of England economists argue that heavy reliance on that opinion lay beneath many of the problems in the financial crisis.

Their paper, Financial Stability Paper No. 9, puts it plainly. Common, often mechanical reliance on ratings for information, certification and regulation lies beneath many of the crisis’s problems.

From private opinion to part of the plumbing

Rating agencies began as private firms selling investors their considered view of a borrower’s credit quality. They still do that job. Their role has grown, though, and the Bank of England authors say ratings are now wired into financial contracts, investment processes and regulation.

That growth changes what a downgrade means. Because so much hangs on them, an agency’s decisions can have consequences for the whole financial system.

What went wrong

The paper lists the charges that policymakers and commentators made after the crisis:

  • faulty rating methods
  • conflicts of interest
  • banks, investors and regulators relying on ratings too much

Both the United States and Europe passed new laws that brought the agencies further under regulation.

What an agency says a rating is for

Standard & Poor’s gave its own view in a chapter published by the International Monetary Fund. It says a rating addresses one part of an investment decision, credit quality, and investors sometimes use ratings wrongly for other purposes. A rating, in its words, is an opinion on the relative creditworthiness of an issuer or an issue. It does not say whether a security suits any one investor.

The chapter backs regulation that makes agencies publish how their ratings performed across asset classes and regions. It also supports disclosure of the criteria and methods behind each rating, and of the models and assumptions used. It draws one line. Regulation should never dictate how an agency does its analysis.

Who pays for a rating

Agencies on an issuer-pay model get confidential information from the companies they rate, both while rating and while monitoring. Standard & Poor’s argues that regulation managing conflicts of interest well can only help the market.

The Bank of England economists go further. They want the first priority to be less reliance on ratings. Where agencies keep strong influence, they say there may be a case for structural measures aimed at the conflicts in how ratings get produced.