Large credit rating agencies (RAs), such as S&P, have come under increasing criticism in recent years for a number of reasons. First, the RAs maintain close relationships with the management of the companies they rate. These connections are characterized by frequent meetings, during which the RAs provide advice on actions companies should take to maintain current ratings. This practice fosters a familial atmosphere that interferes with independent, unbiased rating judgments. Furthermore, because the RAs are paid by the companies they rate, rather than the investors they are meant to protect, a clear conflict of interest exists.

Second, because the rating business is reputation based (why pay attention to a rating that is not recognized by others?), barriers to market entry are high and RAs are oligopolists (an oligopoly is a market dominated by just a few sellers). Thus, the RAs are somewhat immune to forces that apply to competitive markets and, to an extent, can set their rules.

Finally, in many instances, the debt markets (through lower bond prices) have recognized a companys deteriorating the credit quality many months before a rating downgrade occurred. This fact has led many observers to suggest that, rather than rely on ratings, investors and regulators should use credit spreads to make judgments about credit risk. (Credit spreads reflect the difference in yields between interest rates on safe debt, such as Treasury securities, and rates on risky debt such as B-rated bonds.)

To what extent are credit ratings valid? Do the criticisms of RAs have merit?