What do rating agencies do and when can conflicts arise?

• A. They assess credit risk of issuers or tranches
• B. They set monetary policy
• C. They underwrite securities
• D. They insure defaults on securitized products

Answer: (A)

Rating agencies provide independent assessments of credit risk by evaluating whether a borrower or a securitized tranche will meet its obligations and then assigning a credit rating that investors can use to gauge risk and price securities. Conflicts arise mainly because ratings are typically paid for by the issuers being rated, which can create incentives to flatter ratings to win or preserve business, or to avoid downgrades that could raise costs or harm relationships. In structured finance, these tensions can be sharper, since multiple tranches with different risk profiles are rated for the same deal, balancing the need to attract investors with the imperative to reflect true risk accurately. Regulatory and market reliance on ratings for capital requirements and investment mandates can further press agencies to provide favorable ratings. These dynamics illustrate why ratings matter and how incentives can influence them. The other options describe functions rating agencies do not perform: they do not set monetary policy, underwrite securities, or insure defaults.