Non-rating Revenue and Conflicts of Interest

Bo Becker is Professor of Finance and Ramin Baghai is Associate Professor of Finance at the Stockholm School of Economics. This post is based on their recent paper.

Credit rating agencies produce one of the key technologies of the financial system. Ratings have been in use for more than a century, and their application has continuously expanded to new types of financial securities and contracts. Regulations, contracts, investment mandates, capital requirements, loan pricing, all frequently rely on credit ratings.

The expanded use of credit ratings has not been without difficulties and setbacks. Inflated ratings played an important role in the financial crisis of 2008-2009, when large losses on structured securities that had received overly optimistic ratings at issue contributed to destabilizing the financial system (e.g., Benmelech and Dlugosz 2009). Consequently, the production and use of ratings have been subject to more questions and scrutiny in the decade since the financial crisis than ever before, from academics, the public, and policymakers (see, e.g., White 2010, Sangiorgi and Spatt 2017).

Fundamentally, the concerns with the ratings system are related to rating agencies’ business model: their main revenue source is the issuers whose securities they rate. Issuers always benefit from favorable (high) ratings on them or their securities. The flow of money from issuers to raters leads to a conflict of interest between producers of ratings (the agencies) and users of ratings (such as investors). In this context, any commercial relationship between raters and clients is potentially important.

In a recent paper (Baghai and Becker 2018), we examine the provision of non-rating services by raters, as well as the flow of payments between rated issuers and the agencies that issue ratings. Non-rating services include consulting related to ratings, risk management, debt restructuring, regulation, and credit risk. Consulting revenues may be as important as, or more than, ratings fees, both since the amount of services can vary over time, and because the payment terms may be more fungible. We employ data reported by Indian rating agencies—including local subsidiaries of S&P, Moody’s, and Fitch—under regulation that took effect in 2010. Although public placements of corporate bonds are less important in India than in the US or Europe, the role of ratings in India is generally similar to that in more advanced financial systems. This previously untapped Indian data provides a detailed picture of the commercial ties between issuers and raters, including information on payments for non-rating services.

In a sample of ratings issued between 2010 and 2015, we compare ratings levels for a given issuer, across agencies. We find a small apparent bias favoring issuers that generate more business for an agency: an issuer is on average rated 0.3 notches higher by a rating agency that it has hired for non-rating services (than its ratings by agencies that are not hired for such services). Among consulting clients, those issuers that generate higher revenues have the highest ratings (relative to ratings from agencies with less consulting revenue from the same issuers). These effects are particularly large for issuers close to thresholds in the ratings spectrum that are important for regulatory and contracting purposes, such as BBB-.

There are two explanations for these higher ratings: either payment for consulting services is related to lenient treatment by agencies, or the provision of such services is associated with learning. In the second, benevolent interpretation, consulting clients are perceived as safer borrowers by the rating agency that does consulting (but not by its peers), and this effect is stronger for consulting clients that pay higher fees. A direct way to test these competing interpretations is to examine default rates of firms that pay for consulting and those that do not; if the higher ratings of consulting clients are warranted, then—within a given rating category—default rates should be similar for issuers that are consulting clients and issuers that are not. Instead, we find that issuers that pay for consulting services have much higher default rates; this effect is increasing in the amount of fees paid.

Overall, these results are consistent with a fee-driven conflict of interest between rating agencies and security issuers: when an issuer is directly important to an agency through the fees it generates, the ratings it receives are upward biased.

Our paper highlights the potential benefit for the financial system of circumscribing rating agency consulting specifically and fee flows between issuers and raters more generally. Non-rating activities could potentially be prohibited entirely (although this suggestion must be scrutinized for possible negative side effects). As an alternative, increased disclosure may facilitate scrutiny by investors and outsiders of the role non-rating fees play. If data of the type we use were routinely available for the large fixed income markets, there would be scope for outsiders to assess the risk of bias in individual ratings. For corporate issuers, who typically publish annual reports and other public accounting statements, disclosure of the type mandated for their relationships with accountants might prove a template.

The complete paper is available for download here.


Baghai, R., Becker, B., 2018. Non-rating revenue and conflicts of interest. Journal of Financial Economics 27, 94-112.

Benmelech, E., Dlugosz, J., 2009. The credit rating crisis. In: Acemoglu, D., Rogoff, K., Woodford, M. (Eds.), NBER Macroeconomics Annual 2009, Volume 24. University of Chicago Press, Chicago, pp. 161-207.

Sangiorgi, F., Spatt, C., 2017. The Economics of Credit Rating Agencies. Foundations and Trends in Finance, forthcoming.

White, L., 2010, The Credit Rating Agencies. Journal of Economic Perspectives 24(2), 211-226.

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