competition in rating agencies

8/3/2019 Competition in Rating Agencies

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COMPETITION IN RATING

AGENCIES


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Credit ratings make informationabout default likelihoods andrecovery rates of a security

widely available, limiting duplicationof effort in financial markets. Theyallow uninformed

investors to quickly assess the broadrisk properties of tens of thousands ofindividual securities using a single and

well-known scale.


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The industry is dominated by onlythree players Moodys, Standard &Poors (S&P), and Fitch with Fitch

only gaining prominence in the pastdecade or so.

Ratings issued by agencies the

investors use them for free.

The Securities and ExchangeCommission (SEC) now recognizes

ten firms as Nationally Recognized


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Paul Schott Stevens, the President ofthe Investment Company Institute,stated I firmly believe that robust

competition for the credit

rating industry is the best way topromote the continued integrity and

reliability of their ratings.


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Founded in 1913 Fitch.

1989 when a new management team

recapitalized Fitch. This was followed by a merger in

1997 with IBCA Limited, which

specialized in coverage of financialinstitutions.

Fitchs continued growth from this

year forward was both organic andinor anic includin the ac uisitions


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Fitchs corporate ratings wascemented by the July 1, 2005inclusion into the Lehman (now

Barclays Capital) Index thatdifferentiates between investment-grade and junk (high-yield) bonds.

Prior to this change, Lehmanassigned the lower of Moodys orS&Ps rating to any corporate bond,

and thus in situations where one of


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we focus on two dimensions ofquality: the

ability of ratings to transmitinformation to investors and theirability to classify risk.

The basic intuition behind thisinterpretation of quality is as

follows:-


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ratings inflation may hurt theinformation

transmission of ratings if not allinvestors are sophisticated.

inflation will make regulation and

contracting with ratings more difficult(since these rely on stable meaningsof the categories).


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The evidence we uncover appearsunequivocally consistent with lowerratings quality as competition

increased. First, ratings issued byS&P and Moodys rose (moved closerto the top rating of AAA) as

competition increased. Second, theability of S&Ps and Moodys ratingsto explain bond yields decreasedwith competition. In other words,credit ratings are less informative


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speculative grade firms are 7.7times as likely to default within threeyears as investment grade firms

when competition is low (Fitchmarket share is at the 25thpercentile), but only 2.2 times as

likely when competition is high(market share at the 75th percentile).

individual bonds which are rated by

Fitch tend to have lower ratings from


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Another possibility is that Fitchmight find it easier to enter and growin industries where

S&P and Moodys neglect firms andtherefore produce uninformativeratings.

This story does not explain ourresults about

ratings levels, and leavesunex lained the basic issue of wh


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Fitchs ratings are more in demandwhen default is harder to predict,possibly owing to industry opacity or

rates of industrial change. why would ratings be higher when

default is difficult to predict?

Revenues and profits of raters grewquickly over the sample period. Forexample, from 1997 to 2007, roughly

corresponding to our sample period,


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Fitch does not appear to havegained a higher market share whenpredicting default was hard.

raters concern for their reputationsas providers of honest and accurateratings may help sustain ratings

quality. By providing accurateratings, they improve future business

opportunities.


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For a rating agency.. (S&P) claimedthat reputation is more importantthan revenues.

The reputational theories argue thatcompetition can threaten quality byreducing future rents, but it appearslikely that the massive expansion inthe ratings industry during our

sample period generated increases in


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If market size affects the payoff tohigh quality (more expected futurebusiness, as the firms reputation for

quality is maintained) and the payoffto low quality (more business orhigher fee revenue from bond

issuers) similarly, reputationalconcerns would appear unaffected bymarket size. If the market expansionis temporary, the incentives to cheatmay in fact be enhanced by market


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ratings inflation could be thephenomenon of

Ratings shopping that hascome to describe the process by whichissuers shop around for good ratingsand that ultimately the ratings we

observe are the ones that wereconsidered most positive by issuers.


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Skreta and Veldkamp show thatincreases in asset complexity (suchas mortgagebacked

securities and CDOs) leads to moreratings shopping and a systematic biasin disclosed

ratings.

As Spatt (2009) points out, ratingsshopping can only occur if thesecurit issuer ets to choose which


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Even if an issuer refuses to pay for arating, the raters publish it anywayas an unsolicited rating, and thereby

compromise any potential advantageof ratings shopping.

We find that S&Ps and Moodysbond ratings are slightly lower forbonds that have a Fitch rating

(controlling for observables). This is


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Bongaerts, Cremers, and Goetzmann

(2010) find that Fitch ratings tend to

be higher than those issued by S&P

and

Moodys, but reject this as evidence

of ratings shopping or two importantreasons. First, investors do not lower

credit


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We conclude that competition mostlikely weakens reputationalincentives for providing

quality in the ratings industry, andthereby undermines quality. Thereputational mechanism appears to

work best at modest levels ofcompetition.

There are a number of caveats and


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Our findings may shed light on someof the regulatory changes that havebeen contemplated and

implemented for the credit ratingsindustry, including increasedcompetition. . Further competition it

is not likely to improve quality. Ourfindings indicate that quality in theratings industry relies on rents thatreward reputation-building activitieswhich are costly in the short run. The


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competition might have othereffects, including reducingmonopolistic (or in the case of

ratings, oligopolistic) rents, andadding information to financialmarkets (since raters sometimes give

different ratings).


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competition in rating agencies

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