I blogged extensively about the conflicts of interest that bedevil credit rating agencies (CRAs), their role in the sub-prime mortgage crisis, and proposals to reform the ratings industry. Now here comes more evidence of the moral hazard created by ratings agencies on other financial market agents, this time investment banks.
In an exhaustive comparison study of sovereign debt issuance by emerging economy governments since 1820s, Marc Flandreau, Juan H. Flores, Norbert Gaillard, and Sebastián Nieto-Parra find that CRAs impose considerable costs on the financial markets. The find a sharp increase in the shares of speculative grade debt issuances, far out of proportion to the returns from these risks.
They claim that modern financial market regulation, by separating the processes of credit rating by CRAs and underwriting by investment banks, has encouraged more, not less, risk-taking. Further, this arrangement "insulates investment banks from reputational rewards" and the need to "win market share in such debt issuance by building a reputation for quality products".
Insulated and emboldened by the "liability insurance" provided by rating agencies, "underwriters have given up their former role as gatekeepers of liquidity and certification agencies to become aggressive competitors in a new Speculative Grade market".
Update 1 (25/4/2010
Gretchen Morgenson on how Wall Street was given access to the formulas behind those magic ratings and how they hired away some of the very people who had devised them.