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Researchers Call for Strict Liability to Improve Rating Accuracy

Increasing the liability of credit rating agencies would in turn induce credit rating agencies to increase the accuracy of ratings, according to a paper from two Dutch researchers. Alessio Pacces and Alessandro Romano propose a system in which rating agencies are strictly liable in the event of default of a bond or company that they have rated. In order to protect the agencies from collapse and to further improve ratings, the authors recommended measures to limit damages.

The paper proposed that liability would be capped at a limit based on the income received for the rating divided by the probability of default associated with the rating, thus imposing a higher amount of damages for a higher rating. According to the authors, this downward pressure on ratings would counteract the upward pressure applied by issuers though rating-shopping.

The authors also suggest allowing a rating agency to choose a level of “commitment” to the rating, which would publicly indicate their level of confidence in the assigned rating and would affect liability in the event of default. Lastly, the paper suggests that rating agencies should not be responsible for defaults due to systemic risk, with liability expiring after three months for corporate bonds and using observations of rating inflation over certain time periods for structured finance products. 

A summary of the paper can be found here, and the full paper can be accessed here