The Business Ethics Blog

Here’s a very good story on conflict of interest at credit rating agencies, by David Segal, for the NY Times: Debt Raters Avoid Overhaul After Crisis

When the financial crisis began, few players on Wall Street looked more ripe for reform than the Big Three credit rating agencies.

It wasn’t just that Moody’s Investors Service, Standard & Poor’s and Fitch Ratings, played a crucial role in the epochal housing market collapse, affixing their most laudatory grades to billions of dollars worth of bonds that went bad in the subprime crisis.

It was the near universal agreement that potential conflicts were embedded in the ratings model. For years, banks and other issuers have paid rating agencies to appraise securities — a bit like a restaurant paying a critic to review its food, and only if the verdict is highly favorable.

In a conflict of interest (COI), an individual (or organization) trusted to make some judgment on behalf of someone else has an “outside” interest (often but not always a financial interest) that gives reason to doubt their ability to exercise that judgment objectively. Importantly, COI is a feature of a situation, not a feature of a person, and we don’t need any evidence of actual bad decision-making in order to spot a COI. All we need is to see that the person (or organization) expected to make the decision is liable to be pulled in different directions. So, imagine looking at the role of credit rating agencies prior to the recent economic troubles. You might well have found yourself saying, “Wow, I don’t know if they actually give good advice or not, but it sure looks like a conflict of interest because, while they’re supposed to be giving good advice to the investing public, they also have a financial motive to rate bonds highly.”

Notice also that the COI here is not just incidental. It’s built right into the way these firms operate. It’s a structural COI, not amenable to being remedied by, say, simple changes in which individuals make which decisions. The COI here is rooted in the way the relevant institutions are structured.

Third, it’s worth recalling (as I’ve mentioned before on this blog) that COI in itself is not always blameworthy. For one thing, people can find themselves thrust into a COI through no fault of their own. (Imagine you’re asked to hire someone new for your office, and a relative of yours applies for the job. You’re now in a COI. Being in this COI is not your fault, though how you handle it is very much an ethical issue.) But in cases of structural COI, someone has actually built a system to which COI is endemic. But even then, the COI may not be blameworthy: it may well be that a particular system, even if it involves a structural COI, is the best (or least-bad) system available.

Finally, note that the term “conflict of interest” almost seems insufficient, here. As I said above, to spot a COI you don’t have to have evidence that decisions are actually being made badly, or that bad advice is being given. There just has to be reason to doubt the decision-maker, based on the situation they are in. But in the present case, there seems to be ample evidence not just that the bond-raters at these companies were in a conflict of interest, and not just that it was a structural conflict of interest, but indeed that they were in fact giving out very bad advice to people who were relying heavily upon it.

That is why critics, rightly, are calling for change.

Of course, the question of what would count as a better system, and just how far that system would be from the current one, is a hard technical question, one I’ll leave to others with the relevant expertise.

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(For more on COI, see the chapter I co-authored on the topic in this volume, which I recommend highly: The Oxford Handbook of Business Ethics.)