Synergy – or conflict of interest?

“What used to be a conflict is now a synergy,” said then telecom securities analyst Jack Grubman in an economically frothier time. Conflict of interest aficionados will remember that that story didn’t end well – and not just for Grubman, but the larger industry of which he was a part.

The credit ratings industry has long been the focus of similar conflict of interest concerns – particularly those arising from the receipt of consulting-related fees from issuers whose credit-worthiness the agencies are rating. In a posting this week on the Harvard Law School Corporate Governance and Financial Regulation Forum, Professors Bo Becker and Ramin Baghai of the Stockholm School of Economics  describe their recently published research findings related to this area:

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…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.

In other words, maybe it really is a synergy this time!

Or not – as the authors continue:

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. 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).

This seems to me to be an important finding – not just with respect to the topic at hand (COIs in credit ratings agencies) but for the broader point of COIs being more harmful than is generally appreciated.  Finally, the research results may also be a useful source of caution for companies looking for synergistic opportunities without due regard for conflict of interest risks.