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FRM Exam Part I · External and Internal Credit Ratings

Limitations and Criticisms of External Credit Ratings

Updated 11 October 2026 · Fact-checked

External credit ratings are opinions on default risk from agencies such as S&P, Moody's and Fitch. Their main limitations are slow adjustment to new information, conflicts of interest under the issuer-pays model, poor performance on structured products in 2007-09, and investor over-reliance. To answer exam questions, name the flaw, link it to its cause, and state the consequence.

Understand Limitations and Criticisms of External Ratings

An external credit rating is an independent opinion from a rating agency on how likely a borrower is to default, and sometimes on how much loss lenders would suffer. Investors, regulators and banks use ratings as a shortcut instead of building their own credit analysis.

The first limitation is timeliness. Agencies aim to rate through the cycle, so they avoid changing ratings for temporary swings. This keeps ratings stable, but it means they often lag market prices, credit spreads and CDS levels. Downgrades tend to come after the market has already repriced the risk. Ratings also move in steps (notches), so a slow decline may be visible only after a large cumulative change. When deterioration is fast, a downgrade can arrive late and then be severe, which triggers forced selling.

The second limitation is conflict of interest. Under the issuer-pays model, the entity being rated pays the agency. The agency may be tempted to give favorable ratings to keep the business, and issuers can shop around for the best rating. The alternative, an investor-pays model, has its own issues, such as free-riding by non-subscribers. Reputation is the main check on the issuer-pays conflict, but in structured finance fees were large and concentrated in a few arrangers, which weakened that check.

The third limitation is model and rating failures on structured products in 2007-09. Many senior tranches of mortgage-backed securities and CDOs were rated AAA, the same label as very safe corporate or sovereign debt. But the ratings relied on assumptions about low default correlation and rising house prices, and on limited historical data. When housing fell, correlations jumped and many AAA tranches were downgraded many notches or defaulted. A key point: the same letter grade meant different risk distributions for corporate bonds and structured tranches. Structured ratings were far more sensitive to systematic risk.

The fourth limitation is over-reliance. Regulation, investment mandates, collateral rules and risk-weight frameworks hard-wired ratings into decisions. This creates cliff effects: a downgrade below a threshold forces sales or higher capital, which amplifies stress and herding. Ratings also say little about price, liquidity or the full loss distribution. They are an input to risk management, not a replacement for internal analysis.

How to solve Limitations and Criticisms of External Ratings questions

Use this method for any conceptual or scenario question on rating criticisms.

  1. 1Identify which limitation the question points to: timeliness, conflict of interest, structured product failure, or over-reliance.
  2. 2Recall the cause. Timeliness: through-the-cycle approach and notch-based adjustments. Conflict: issuer-pays and rating shopping. Structured: correlation and house price assumptions. Reliance: regulatory and mandate hard-wiring.
  3. 3State the consequence: lagging downgrades, inflated ratings, sudden mass downgrades, cliff effects or herding.
  4. 4Check whether the question asks about corporate or structured ratings. Structured ratings are more sensitive to systematic risk.
  5. 5Eliminate options that overstate: words like 'always', 'eliminates' or 'proves fraud' are usually wrong.
  6. 6Pick the option that matches both the cause and the consequence, and that keeps ratings as an input rather than a verdict.

Quickest way: Cause-and-effect matching

When to use it: Use for multiple-choice questions where you must match a criticism to its cause or effect in under a minute.

  1. Underline the key phrase: 'lag', 'issuer pays', 'AAA tranche', 'regulatory threshold'.
  2. Match it: lag = through-the-cycle; issuer pays = rating shopping; AAA tranche = correlation and house price assumptions; threshold = cliff effect.
  3. Drop options that reverse the logic, such as saying the issuer-pays model reduces conflicts.
  4. Choose the remaining option and move on.

Common mistakes in Limitations and Criticisms of External Ratings

  • Saying ratings are always slower than markets because agencies are careless.

    Students ignore the through-the-cycle design.

    Fix: Explain that stability is intentional. The cost is lag relative to spreads and CDS prices.

  • Claiming the issuer-pays model proves agencies knowingly gave false ratings.

    Mixing up an incentive problem with proven misconduct.

    Fix: Say it creates a potential conflict and rating-shopping pressure. Do not state it as proof of intent.

  • Treating an AAA structured tranche as equal in risk to an AAA corporate bond.

    The letter grade looks identical.

    Fix: Remember structured tranches depend heavily on correlation and systematic factors, so they can suffer multi-notch downgrades together.

  • Blaming only the agencies for the 2007-09 crisis.

    Ratings are an easy headline cause.

    Fix: Note that investors, banks and regulators also over-relied on ratings. Agencies were one contributing factor among several.

  • Ignoring cliff effects when asked about reliance.

    Students focus on accuracy only.

    Fix: Mention that rating-based rules force sales and capital increases at thresholds, amplifying stress.

Worked examples

Example 1

A bank holds a senior tranche of a mortgage CDO rated AAA. During 2008 it is downgraded to below investment grade within months. Which explanation best fits the rating failure? A) Default correlation was assumed to be low and house prices were assumed to keep rising. B) Agencies rated through the cycle, so the tranche was rated too conservatively. C) The tranche was backed by sovereign guarantees. D) Rating notches are too wide for corporate bonds.

Show the solution
  1. Identify the topic: structured product rating failure.
  2. Recall the cause: structured ratings relied on low correlation and rising house price assumptions with limited data.
  3. Test A: matches. When house prices fell, correlation rose and losses hit senior tranches.
  4. Test B: through-the-cycle ratings are stable, not overly conservative here; the tranche was rated too high.
  5. Test C: mortgage CDO tranches had no sovereign guarantee.
  6. Test D: not relevant to a structured tranche.

Answer: A

Example 2

An analyst says a corporate issuer's rating still shows A while its CDS spread has widened sharply for months. Which pair of limitations does this best illustrate? A) Timeliness and the through-the-cycle approach. B) Regulatory arbitrage and model risk. C) Investor-pays bias and free-riding. D) Rating shopping and notching error.

Show the solution
  1. Observation: market prices signal deterioration while the rating is unchanged.
  2. This is a lag in ratings versus market information.
  3. Agencies deliberately smooth ratings through the cycle, causing this lag.
  4. Option A names exactly this pair.
  5. The other options describe conflicts or regulatory issues, not a lag between ratings and spreads.

Answer: A

Exam tips

  • Expect scenario questions that describe a symptom, such as a late downgrade or an inflated AAA, and ask for the cause.
  • Link each criticism to one mechanism and one consequence. Examiners reward this pairing.
  • Watch for absolute wording like 'always' or 'eliminates'. These options are usually wrong.
  • Keep corporate and structured ratings separate: structured ratings are more exposed to correlation and systematic risk.
  • Remember ratings are inputs to risk management, not substitutes for internal analysis.

Practice questions from External and Internal Credit Ratings

Limitations and Criticisms of External Ratings in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Limitations and Criticisms of External Ratings: frequently asked questions

What is the main conflict of interest in credit rating agencies?

Under the issuer-pays model, the borrower being rated pays for the rating. This can push agencies toward favorable ratings to keep business and lets issuers shop for better ratings. Reputation is the main restraint.

Why were AAA structured products downgraded so heavily in 2007-09?

Their ratings relied on low default correlation, rising house prices and limited data. When house prices fell, mortgage defaults rose together, so losses reached senior tranches and many were downgraded by several notches.

Why are external ratings slow to change?

Agencies use a through-the-cycle approach that ignores temporary swings to keep ratings stable. This reduces rating reversals but makes ratings lag market signals such as credit spreads and CDS levels.

What is over-reliance on ratings?

It means investors, regulators and mandates use ratings as a substitute for their own analysis. Rating thresholds in rules can cause forced selling or higher capital when a downgrade happens, amplifying stress.