A Strict Liability Regime for Rating Agencies

In order to appreciate why a strict liability rule shaped in such a way would provide Credit Rating Agencies (CRA) with optimal incentives to issue accurate ratings, the authors start with discussing in Part I what is broken in the market for rating. In Part II, they introduce the strict liability r...

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Bibliographic Details
Published inAmerican business law journal Vol. 52; no. 4; pp. 673 - 720
Main Authors Pacces, Alessio M., Romano, Alessandro
Format Journal Article
LanguageEnglish
Published Oxford, Ohio Blackwell Publishing Ltd 01.12.2015
Academy of Legal Studies in Business
Subjects
Liability
Negligence
Organizational behavior
Rating services
Reputations
United States > US
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Summary:In order to appreciate why a strict liability rule shaped in such a way would provide Credit Rating Agencies (CRA) with optimal incentives to issue accurate ratings, the authors start with discussing in Part I what is broken in the market for rating. In Part II, they introduce the strict liability rule with a simple numerical example. In Part III, they illustrate in two phases how capped strict liability prevents CRAs from inflating ratings. First, they present this result under simplifying assumptions. Second, they show that the choice of liability exposure by CRAs can lead to the same result under the more realistic assumptions of imperfect foresight and unobservability of reputation effects and other key variables. In Part IV, they discuss the problem of systemic risk and how the strict liability rule should be corrected to cope with this problem in the two cases of corporate bonds and structured finance products. Part V illustrates the key advantages of the proposal in disciplining CRAs' behavior.
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A previous version of this article was published as ECGI research paper in law and a short summary of it was posted on the Harvard Law School Forum on Corporate Governance and Financial Regulation. Part of the research included in this article was carried out at the Study Center Gerzensee of the Swiss National Bank, whose hospitality is gratefully acknowledged. This article benefited from the feedback of participants in the 2014 European Summer Symposium on Economic Theory (ESSET) in Gerzensee, the 2014 MaCCI Law and Economics Conference on Financial Regulation and Competition in Mannheim, the 2013 Meeting of the Canadian Association in Law and Economics in Toronto, the 15th Joint Seminar of the European Association of Law and Economics and the Geneva Association in Girona, the 4th Annual Conference of the Spanish Association of Law and Economics in Granada, and the 11th Annual Meeting of the German Association of Law and Economics in Bolzano. We thank Gaia Barone, Patrick Bolton, Jeff Gordon, Alice Guerra, Martin Hellwig, Todd Henderson, Claire Hill, Giovanni Immordino, Yair Listokin, Vyacheslav Mikhed, Marcello Puca, Pietro Reichlin, Roberta Romano, Ulrich Schroeter, Alan Schwartz, Bob Scott, Angela Troisi, and Roland Vaubel for valuable comments on previous versions of this work. The usual disclaimers apply.
ISSN:0002-7766
1744-1714
DOI:10.1111/ablj.12054