Competition is a key driver for constant growth and improvement within an organisation. Spanning from increased productivity to innovation of products and processes, an organisation which is not challenged by a peer it in its industry is most likely to lack the ambition to improve beyond its current abilities. Consumers are forced to accept the products given, without a sufficient benchmark.
Moreover, policies are in place to prevent large organisations from abusing their dominant positions in their relative industry, in order to protect consumers as well as other businesses. Agencies are established, often by the government, with the core purpose of enforcing and regulating competition laws as well as protecting consumer rights. Examples of these are the Competition and Markets Authority (CMA) and the Financial Conduct Authority (FCA) in the UK.
One industry noticeably treated with more lenience in this regard is the credit rating industry. Credit rating agencies are an integral part of the financial services industry. They have a major role to play in the decisions that investors make and therefore influence the movement of capital. Credit rating agencies provide investors with information about whether debt and bond issuers can meet their obligations. These span from corporate bonds to sovereign bonds. The creditworthiness of an issuer is indicated by the rating assigned. Starting at AAA and ending at C, higher rated securities are investment grade and lower rated securities are speculative grade, meaning the company or country is less likely to be able to pay back the debt.
The three dominant players in the market, “The Big Three”; are Standard & Poor’s, Moody’s and Fitch Ratings. These agencies were established in 1860, 1909 and 1913, respectively. The historical feature renders it unsurprising that they hold 95% of the market share.
Operating in an oligopoly allowed these agencies to become too comfortable. Although these ratings are based on statistics, they are still an opinion belonging to the irrational human mind, no matter how shrewd the analysts are perceived to be. A highly concentrated market decreases the threat of new entrants and the need to justify the underlying data behind these decisions.
Additionally, there is a consensus that credit rating agencies contributed to the 2008 financial crisis. These key credit rating agencies provided mortgage-backed securities that proved to be high risk with AAA ratings. Clearly this misled many investors who believed they could trust their sources of information. Withonly a few dominant players in the market, the incentive to collude is heightened and results in inflationary ratings. An official report on the 2008 financial crisis called out these agencies as “essential cogs in the wheel of financial destruction”. Although tightened regulation was said to be a priority after the 2008 crisis, the question remains whether this has improved the reliability of rating agencies.
The business model of credit rating agencies is inherently flawed. By receiving payment from the issuers they assess; it is a structure that can cause conflicts and moral hazard. The entities receiving the ratings care about good ratings, not necessarily accurate ones. Consequently, issuers are far more benefited by these ratings than the investors as the signal of creditworthiness could be skewed. Therefore, the role of credit rating agencies risks becoming redundant. Although there are protocols and procedures for managing conflicts of interest, experience shows these may not stretch far enough.
An example of this issue can be observed as S&P and Moody’s agreed to pay $1.4bn and $864m respectively to the US in order to settle allegations that it boosted ratings of mortgage-backed securities in lead up to the 2008 crisis. The main motives behind delaying downgrades was the fear of losing market share. There have been questions about whether there is potential for alternative payment models to realign the interests of agencies and investors.
More competition will allow for ratings agencies to provide truly fact-based services and overcome the inertia that pervades the industry. Being able to compare across a larger pool of agencies will allow for discrepancies to be identified and outliers to be questioned. There has been an attempt to tighten regulation over companies based on geographical location, for example the European Securities and Market Authority (ESMA) and FCA. However, there hasn’t been as many comprehensive steps to increase competition.
The outbreak of Covid-19 has brought these agencies under scrutiny once again. The global pandemic resulted in a considerable amount of rating downgrades. Critics liken this to the 2008 financial crisis, where a large-scale downgrade of inflated ratings heightened the sense of alarm and insecurity surrounding financial markets. However, the outbreak was un-precedented and the agencies state they are purely reacting to a change in circumstance.
As with many industries, customers need to have trust in firms. This may create an obstacle for potential competitors. Therefore, regulatory bodies need to do more to aid the establishment of alternative credit rating agencies with international credibility. Although the ESMA claims to be encouraging competition and choice in the ratings market, the ECB precludes this by only accepting bonds rated by the three big agencies as well as DBRS, a Canadian agency.
German rating agency, Scope, was founded 20 years ago and until 2014 mainly focused on Investment Funds. Since then it has been trying to break its way into the global market, however so far it holds just 0.5% of the European Market. Fortunately, the situation for Scope is starting to take a positive turn as companies are taking it upon themselves to foster increased competition amongst credit rating agencies. As with any oligopoly, few players results in higher fees and a tendency towards group thinking, an attribute investors would be wise to avoid. Scope has stated it is currently rating about 30 per cent of the banks and corporates represented in the iBoxx euro investment grade index, a benchmark for professional use.
Like in any industry, innovation is quintessential to the further development and capabilities of these agencies. Unfortunately, without a threat of survival it is unlikely these agencies will meet their full potential. Credit rating agencies need to start receiving the same treatment as other organisations do in terms of anti-trust policy and competition regulations as they are paramount feature of capital markets and heavily influence the movement of finance. Although there has been some attempt to resolve these major issues, it is still far from complete.