Question

Why should we be skeptical about the ratings that rating agencies produce? Identify 3 the three accurate responses:

a. Barriers to entry prevent new rating agencies with better models from gaining market power, thus insulating existing agencies from having to compete on the accuracy of their ratings.
b.To give a low rating to a security, the rating agent must get approval from the agency's board of directors.
c. Rating agencies have other (non-rating-related) business with the same companies they rate.
d. Rating agencies are paid by the companies they rate and compete with each other for business.

Answer 1

Skepticism towards rating agencies is warranted due to barriers to market entry limiting competition, potential conflicts of interest from non-rating-related business, and the issuer-pay model creating incentives for positive ratings.

Step-by-step explanation:

We should be skeptical about the ratings that rating agencies produce for several reasons. Barriers to entry, such as regulation or the need for a strong reputation, prevent new rating agencies with improved models from entering the market easily. This situation leads to less competition and can result in existing agencies not being pressured to improve the accuracy of their ratings.

Conflict of interest can occur because rating agencies may avoid giving low ratings to securities in order not to offend the companies they have other business relationships with or as a result of pressure from these companies. Lastly, the issuer-pay model, where the agencies are paid by the companies whose securities they rate, could create an incentive for them to issue favorable ratings to win business, leading to biased or overly optimistic ratings.

These factors raise questions about the objectivity and reliability of the ratings provided by these agencies. Alternative methods of assessing credit risk and security valuation should be considered alongside these ratings to make well-informed financial decisions.