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FRM Part II · FRM Exam Part II · Credit Scoring and Rating

A structured finance arranger pays a rating agency a fee for rating each new tranche, and the arranger can choose among several agencies before the rating is published. Which criticism of credit ratings is MOST directly raised by this arrangement?

The main criticism is a conflict of interest. Under the issuer-pays model, agencies earn fees from the entities they rate, and issuers can shop among agencies for the best rating, creating pressure toward lenient ratings. Procyclicality is a separate issue concerning the capital effects of rating changes.

  1. AProcyclicality of capital requirements
  2. BConflict of interest from the issuer-pays model combined with rating shoppingCorrect
  3. CLack of ordinal ranking of default risk across grades
  4. DExcessive reliance on market prices in the rating process

Explanation

When issuers pay for ratings and can pick the agency, agencies have an incentive to be lenient to win business. This is the classic issuer-pays conflict plus rating shopping. Procyclicality concerns capital effects of rating migration, not who pays for the rating.

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