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“Comment: Rating the Law – How Financial Agencies are Assessing the Legal Risks of Financial Transactions”, 2 Law and Economics of Risk in Finance (2007)

Abstract

Financial instruments today often are issued along with assessments of their quality by credit rating agencies (“CRAs”). The assessments are in the form of ratings (A, B+, B, etc.). These ratings are based on (a) the risk that the issuer of an instrument will default; and (b) the effectiveness of debt collection conditional on default. The effectiveness of debt collection, in turn, is a function of (c) the quality of the law that will be applied to assess the parties’ rights and obligations; and (d) the efficiency of the legal system in which the instrument will be enforced. The higher is the rating, the lower is the interest rate the issuer must pay.

Professor du Marais and his colleagues analyze the way CRAs condition their ratings on the effectiveness of debt collection. Three such agencies are studied: Standard and Poor, Moody’s and Fitch. The method used was to conduct interviews of “stakeholders”, the CRAs, “top managers of all kinds of issuers”, and staff of the regulators. All of these interviews were conducted in France.

The paper does not distinguish clearly between the quality of law to be applied and the efficiency of the collection system. It is unclear whether the CRAs make this distinction clearly themselves. In any event, the paper has two positive conclusions: (a) CRAs prefer statutes to cases. That is, they give greater weight to a desirable legal rule that is contained in a statute than to the same rule that is the product of high court opinions; and (b) CRAs give greater weight to instruments that will be controlled by and enforced in the legal systems of England and the US than to the French legal system and systems similar to it. The CRAs’ preferences are consequential, amounting to several interest rate points for an issue.

The paper claims that the CRAs are making a mistake. In the authors’ view, CRAs are using “doubtful indicators”, and their preferences reflect “unscientifically based biases”. As a consequence of these deficiencies, CRAs “are undervaluing the bonds and securities issued in markets belonging to the less preferred legal traditions”.

This paper is in the line of papers that make serious studies of private institutions that affect the law and markets. These institutions have not received sufficient scrutiny, so this paper is welcome. In my view, the paper’s positive findings are valuable but its normative critique needs more work. Thus, this Comment should be taken as a request for further research. My remarks are in three categories: market responses; ratings criteria; and data issues.

Date of Authorship for this Version

2007

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