Ratings Agency Reform: Something More Radical Required?

08 Dec 2011

Prof. Karl Whelan

After the global financial crisis triggered by widespread losses on supposedly low risk AAA-rated structured finance products, enthusiastic supporters of the world’s major credit ratings agencies are hard to find.

By even the most basic microeconomic criteria, the structure of the industry is hardly ideal, with the vast majority of ratings provided by the two largest incumbents. Furthermore, their funding model, in which almost all the fees are collected from those who issue securities rather than those who buy them, leaves the agencies wide open to accusations of systematic mis-rating of products in order to generate revenue.

In light of these problems, it is hardly surprising that the European Union has decided to formally regulate the credit ratings agencies via the European Securities and Markets Authority (ESMA). The European Commission has now put forward a new, more extensive, package of proposals which would change the way that ratings are used and provided.

Here I want to focus on two aspects of the proposed reform: The requirement that ESMA approve methodologies underlying ratings and the proposal to boost competition by requiring issuers to rotate their rating provider every three years.

 

ESMA Approval

I am more concerned by the proposals that ESMA have a role in approving the methodologies applied by the agencies. To quote the Executive Summary attached to the package of proposals:

- Articles 8(5a), 8(6)(aa) and 22a(3) … require the consultation of stakeholders on the new methodologies or the proposed changes and on their justification. CRAs should furthermore submit the proposed methodologies to ESMA for the assessment of their compliance with existing requirements. The new methodologies may only be used once they have been approved by ESMA. The rules also require the publication of the new methodologies together with a detailed explanation.

As I discussed in my previous post, European politicians and senior ECB officials have repeatedly criticised the ratings agencies—unfairly in my opinion—in relation to sovereign downgrades. In particular, they have argued—again incorrectly in my opinion—that ratings agencies should not respond to bond market movements.

In light of this background, I am concerned that ESMA officials will be negatively disposed towards methodologies that depend on this source of information. Given the importance of investor sentiment in affecting sovereign default risk, I think such an approach could do severe damage to the usefulness of agency ratings.

 

The Proposed Rotation Rule

There can be little doubt that the ratings industry exhibits a pretty low level of competition, with S&P and Moody’s providing the vast majority of ratings. To address this lack of competition, the Commission is proposing a series of rules that involve issuers having to rotate between various ratings providers. According to these regulations:

The CRA engaged should not be in place for more than 3 years or for more than a year if it rates more than ten consecutive rated debt instruments of the issuer. However, this latter rule shall not lead to shortening the permitted period of engagement to less than a year. Where the issuer solicits more than one rating for itself or for its instrument, be it because of a legal obligation to do so or voluntarily, only one of the agencies has to rotate. However, the maximum duration for each of these CRAs is fixed at a period of six years.

I’ll restrict my comments on these proposals to two observations.

First, I am not sure that Commission’s diagnosis of the source of competition problems is correct. The proposal appears to be based on the assumption that the lack of competition in the ratings industry stems from the existence of long-standing, cosy relations between issuers and their raters, in which issuers have become used to Moody’s and/or S&P and the agencies are happy to provide good ratings as long as they continue to get business from the issuers.

There may be some truth to this but I don’t think the idea of cosy relationships really explains the limited competition in this market. The technical barriers to entry into this industry are not so high (it is not so difficult to put together a team of financial experts to do this kind of analysis) so it’s not clear from this explanation why there aren’t ten different firms each with established long-term cosy relationships with issuers.

Instead, the literature on the credit ratings industry suggests that the implicit barriers to entry associated with reputational issues are considerable. As this nice paper by Claire Hill (2011) discusses, one can find many examples of financial industry specialists who claim that they felt they had to get Moody’s and S&P to rate their securities because investors would be suspicious if they chose to provide ratings by other less well-known agencies. With this reputational advantage, it has been difficult for newcomers to take a lot of business away from the incumbents.

I suspect that these rules will see a lot of businesses rotating between being rated by Moody’s to being rated by S&P, with occasional periods in which a solicited rating means it is being rated by both of the main agencies. The effects in encouraging the growth of new agencies may be limited.

Second, while in most market settings more competition generally produces better outcomes for society, it is not clear that more competition in the credit ratings industry is an example of this general rule, at least not under the current issuer-pays model. Camanho, Deb and Liu (2009) is a well-reasoned paper that illustrates that ratings are even more likely to be inflated if more competitors are introduced into an issuer-pays ratings market. The tendencies of issuers to shop for ratings and for raters to look to keep business by offering a positive credit assessment are greater when there is more competition.

On balance, while I don’t have any great objections to these rules, I'm not sure they will create more competition and, if they do, whether this will provide us with higher-quality ratings.

 

More Radical Reforms Required?

The Commission’s consultation document in relation to these proposals put forward some ideas for more radical changes to the rating agency industry.

A more promising set of proposals relate to a more radical overhaul of the industry, replacing the issuer-pays model and the many incentive problems that go with it. There are many possible alternative models but the principal one that has been discussed involves a central (not necessarily public) body that assigns ratings agencies to issuers.

The funding of such an approach could come from a mix of sources such as a tax on financial institutions or a charge applied to issuers (who no longer pick their raters). This paper by Deb and Murphy provides a well-developed concrete model for how such a system would work, with taxes charged on the financial industry used to provide a subsidy to raters, which is minimised by collecting fees obtained in auctions from ratings agencies bidding for work.

The Commission is proposing to publish a report on credit rating agencies' remuneration models in December 2012. I would encourage them to consider a bold restructuring. Such a move could have a far more positive impact than the full package of proposals that have just been put forward.

 

This content forms part of the E View project, which is part-funded by DG Communication of the European Parliament.

 

  

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