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Industry structure

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Further information: Big Three (credit rating agencies)

The three largest credit rating agencies—Standard & Poor's, Moody's Investor Service, and Fitch Ratings—are collectively referred to as the "Big Three" due to their substantial market share.[1] According to the most recent U.S. Securities and Exchange Commission (SEC) report, the agencies together account for approximately 96% of all credit ratings.[2] A 2011 report by Deutsche Welle reckons their "collective market share" at "roughly 95%".[3][4]

As of December 2012, S&P is the largest of the three, with 1.2 million outstanding ratings and 1,416 analysts and supervisors.[2][5] Moody's is the second largest agency, with 1 million outstanding ratings and 1,252 analysts and supervisors.[2][5] Fitch is the smallest of the Big Three, with approximately 350,000 outstanding ratings, and is sometimes used as an alternative to S&P and Moody’s.[2][6]

Since the establishment of the first agency in 1909, there have never been more than four credit rating agencies with significant market share.[7] Why this concentrated market structure has developed is disputed. One widely cited opinion is that the Big Three's historical reputation within the financial industry creates a high barrier of entry for new entrants.[7] Following the enactment of the Credit Rating Agency Reform Act of 2006, seven additional rating agencies have attained recognition from the SEC as Nationally Recognized Statistical Rating Organizations (NRSROs).[8][9] While these other agencies remain niche players,[10] some have gained market share following the 2008 financial crisis,[11] and in October 2012 several announced plans to join together and create a new organization called the Universal Credit Rating Group.[12] The European Union has considered setting up a state-supported EU-based agency.[13]

The three largest agencies are not the only sources of credit information.[14] Many smaller rating agencies also exist, mostly serving non-US markets.[15] All of the large securities firms have internal fixed income analysts who offer information about the risk and volatility of securities to their clients.[14] And specialized risk consultants working in a variety of fields offer credit models and default estimates.[14]

Business models

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Credit rating agencies generate revenue from a variety of activities related to the production and distribution of credit ratings.[16] The sources of the revenue are generally the issuer of the securities or the investor. Most agencies operate under one or a combination of business models: the subscription model and the issuer-pays model.[17] However, agencies may offer additional services using a combination of business models.[16][18]

Under the subscription model, the credit rating agency does not make its ratings freely available to the market, so investors pay a subscription fee for access to ratings.[17][19] This revenue provides the main source of agency income, although agencies may also provide other types of services.[17][20] Under the issuer-pays model, agencies charge issuers a fee for providing credit rating assessments.[17] This revenue stream allows issuer-pays credit rating agencies to make their ratings freely available to the broader market, especially via the Internet.[21][22]

The subscription approach was the prevailing business model until the early 1970s, when Moody's, Fitch, and finally Standard & Poor's adopted the issuer-pays model.[17][19] Several factors contributed to this transition, including increased investor demand for credit ratings, and widespread use of information sharing technology—such as fax machines and photocopiers—which allowed investors to freely share agencies’ reports and undermined demand for subscriptions.[23] Today, eight of the nine nationally recognized statistical rating organizations (NRSRO) use the issuer-pays model, only Egan-Jones maintains an investor subscription service.[21] Smaller, regional credit rating agencies may use either model. For example, China's oldest rating agency, Chengxin Credit Management Co., uses the issuer-pays model. The Universal Credit Ratings Group, formed by Beijing-based Dagong Global Credit Rating, Egan-Jones of the U.S. and Russia’s RusRatings claimed they are going to uses the investor-pays model.[24][25][26]

Critics argue that the issuer-pays model creates a potential conflict of interest because the agencies are paid by the organizations whose debt they rate.[27] However, the subscription model is also seen to have disadvantages, as it restricts the ratings' availability to paying investors.[21][22] Issuer-pays CRAs have argued that subscription-models can also be subject to conflicts of interest due to pressures from investors with strong preferences on product ratings.[28] In 2010 Lace Financials, a subscriber-pays agency later acquired by Kroll Ratings, was fined by the SEC for violating securities rules to the benefit of its largest subscriber.[29]

A 2009 World Bank report proposed a "hybrid" approach in which issuers who pay for ratings are required to seek additional scores from subscriber-based third parties.[30] Other proposed alternatives include a "public-sector" model in which national governments fund the rating costs, and an "exchange-pays" model, in which stock and bond exchanges pay for the ratings.[28][31] Crowd-sourced, collaborative models such as Wikirating have been suggested as an alternative to both the subscription and issuer-pays models, although it is a recent development as of the 2010, and not yet widely used.[32][33]

Oligopoly produced by regulation

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Agencies are sometimes accused of being oligopolists,[34] because barriers to market entry are high and rating agency business is itself reputation-based (and the finance industry pays little attention to a rating that is not widely recognized). In 2003, the US SEC submitted a report to Congress detailing plans to launch an investigation into the anti-competitive practices of credit rating agencies and issues including conflicts of interest.[35]

Of the large agencies, only Moody's is a separate, publicly held corporation that discloses its financial results without dilution by non-ratings businesses, and its high profit margins (which at times have been greater than 50 percent of gross margin) can be construed as consistent with the type of returns one might expect in an industry which has high barriers to entry.[36] Celebrated investor Warren Buffet described the company as “a natural duopoly,” with “incredible” pricing power, when asked by the Financial Crisis Inquiry Commission about his ownership of 15% of the company.[37][38]

According to professor Frank Partnoy, the regulation of CRAs by the SEC and Federal Reserve Bank has eliminated competition between CRAs and practically forced market participants to use the services of the three big agencies, Standard and Poor's, Moody's and Fitch.[39]

SEC Commissioner Kathleen Casey has said that these CRAs have acted much like Fannie Mae, Freddie Mac and other companies that dominate the market because of government actions. When the CRAs gave ratings that were "catastrophically misleading, the large rating agencies enjoyed their most profitable years ever during the past decade."[39]

To solve this problem, Ms. Casey (and others such as NYU professor Lawrence White[40]) have proposed removing the NRSRO rules completely.[39] Professor Frank Partnoy suggests that the regulators use the results of the credit risk swap markets rather than the ratings of NRSROs.[39]

The CRAs have made competing suggestions that would, instead, add further regulations that would make market entrance even more expensive than it is now.[40]

  1. ^ H. Kent Baker; Gerald S. Martin (2011). Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. Wiley. ISBN 0470569522.
  2. ^ a b c d "Annual Report on Nationally Recognized Statistical Rating Organizations" (pdf). U.S. Securities and Exchange Commission. December 2012.
  3. ^ Alessi, Christopher. "The Credit Rating Controversy. Campaign 2012". Council on Foreign Relations. Retrieved 29 May 2013.
  4. ^ "S&P warning puts damper on Eurogroup plans". 05.07.2011. Deutsche Welle. Retrieved 16 December 2013.
  5. ^ a b Jeannette Neumann (16 November 2012). "SEC says credit rating industry remains plagued by weak oversight". Financial News.
  6. ^ Klein, Alec (23 November 2004). "Smoothing the Way for Debt Markets". The Washington Post.
  7. ^ a b Gerard Caprio (2012). Handbook of Key Global Financial Markets, Institutions, and Infrastructure. Academic Press. p. 386. ISBN 0123978734.
  8. ^ Marie Leone (2 October 2006). "Bush Signs Rating Agency Reform Act". CFO.com. Retrieved 13 May 2013.
  9. ^ "Credit Rating Agencies—NRSROs". U.S. Securities and Exchange Commission. 12 May 2011. Retrieved 13 May 2013.
  10. ^ Arturo Cifuentes (4 March 2013). "Get technical to fix rating agencies". Financial Times. Retrieved 13 May 2013.
  11. ^ Yali N'diaye (26 February 2013). "Analysis: Can The US Rating Landscape Really Change?". Market News International. {{cite news}}: |access-date= requires |url= (help)
  12. ^ Simon Rabinovitch (24 October 2012). "New credit rating agency to align with common interests of human society". Financial Times. Retrieved 13 May 2013.
  13. ^ The Times, 3 June 2010, Europe launches credit ratings offensive
  14. ^ a b c Edward Altman; Sabri Oncu; Anjolein Schmeits; Lawrence White (6 April 2010). "What Should be Done About the Credit Rating Agencies". Regulating Wall Street. New York University. Retrieved 11 October 2013.
  15. ^ Herwig Langohr; Patricia Langohr (2009). The Rating Agencies and Their Credit Ratings. Wiley. p. 384. ISBN 0470018003.
  16. ^ a b "Securities and Exchange Commission: Action Needed to Improve Rating Agency Registration Program and Performance-related Disclosures" (pdf). United States Government Accountability Office. 2010. pp. 60–61.
  17. ^ a b c d e Gerard Caprio (2012). Handbook of Key Global Financial Markets, Institutions, and Infrastructure. Academic Press. ISBN 0123978734.
  18. ^ Lianna Brinded (38 November 2007). "Moody's to boost investor confidence with new data feed". Financial News. {{cite web}}: Check date values in: |date= (help)
  19. ^ a b Pragyan Deb; Gareth Murphy (2009). "Credit Rating Agencies: An Alternative Model" (PDF). London School of Economics.
  20. ^ "General Principles for Credit Reporting" (PDF). World Bank. September 2011. In some countries, credit rating agencies are starting to provide other types of services, including credit reporting services.
  21. ^ a b c Stephen Foley (14 January 2013). "Issuer payment: model resistant to reform". Financial Times.
  22. ^ a b "Issuer-pays model ensures ratings are available to the entire market". The Economic Times. 6 May 2010.
  23. ^ John (Xuefeng) Jiang; Mary Harris Stanford; Yuan Xie (2012). "Does it matter who pays for bond ratings? Historical evidence" (PDF). Journal of Financial Economics.
  24. ^ John Morgan (26 October 2012). "Credit Ratings Agencies from China, Russia and the US Join Forces". Moneynews.com.
  25. ^ Katie Hunt (31 October 2012). "China ratings firms challenge US dominance". BBC.
  26. ^ Norbert Gaillard (2011). A Century of Sovereign Ratings. Springer. p. 90. ISBN 146140522X.
  27. ^ Gwynneth Anderson (April 2011). "New raters enter the Fray". Treasury & Risk.
  28. ^ a b Damien Fennell; Andrei Medvedev (November 2011). "An economic analysis of credit rating agency business models and ratings accuracy" (PDF). Financial Services Authority. p. 19. Cite error: The named reference "FSA" was defined multiple times with different content (see the help page).
  29. ^ Jeannette Neumann; Aaron Lucchetti (6 September 2010). "Ratings Firm is Fined in Misstate Case". The Wall Street Journal.
  30. ^ Jonathan Katz; Emanuel Salinas; Constantinos Stephanou (October 2009). "Credit Rating Agencies: No Easy Regulatory Solutions" (pdf). The World Bank Group.
  31. ^ "Report of the Committee on Comprehensive Regulation for Credit Rating Agencies" (pdf). Securities and Exchange Board of India. December 2009.
  32. ^ John Greenwood (28 January 2012). "Wiki joins rating game". Financial Post.
  33. ^ Yali N'Diaye (26 November 2012). "Crowd Sourced Rating Firms Join Forces;Target SEC Registration". MNI. Deutsche Boerse Group.
  34. ^ "Measuring the measurers". The Economist. 31 May 2007.
  35. ^ Teather, David (28 January 2003). "SEC seeks rating sector clean-up | Business". London: The Guardian. Retrieved 10 May 2009.
  36. ^ « Dagong, the new Chinese bad guy or a fair player ? », SACR, 21 mars 2012.
  37. ^ The Financial Crisis Inquiry Report (PDF). National Commission on the Causes of the Financial and Economic Crisis in the United States. 2011. p. 207.
  38. ^ Buffet explained that pricing power was what was important in his purchase of Moody's stock. `... he knew nothing about the management of Moody’s. “I had no idea. I’d never been at Moody’s, I don’t know where they are located.”` (source: The Financial Crisis Inquiry Report)
  39. ^ a b c d A Triple-A Idea—Ending the rating oligopoly, Wall Street Journal, April 15, 2009
  40. ^ a b AAA Oligopoly, The Wall Street Journal, FEBRUARY 26, 2008
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