The Independence of Credit Rating Agencies: How Business Models and Regulators Interact

By Gianluca Mattarocci

The Independence of Credit Rating Agencies focuses on the institutional and regulatory dynamics of these agencies, asking whether their business models give them enough independence to make viable judgments without risking their own profitability.

Few have closely examined the analytical methods of credit rating agencies, even though their decisions can move markets, open or close the doors to capital, and bring down governments. The 2008 financial crisis highlighted their importance and their shortcomings, especially when they misjudged the structured financial products that precipitated the collapse of Bear Stearns and other companies.

This book examines the roles played by rating agencies during the financial crisis, illuminating the differences between U.S. and European rating markets, and also considers subjects such as the history of rating agencies and the roles played by smaller agencies to present a well-rounded portrait.

• Reports on one of the key causes of the 2008 financial crisis: agencies that failed to understand how to analyze financial products
• Describes inherent business model and pricing conflicts that compromise the independence of credit rating agencies
• Reveals how rating agencies large and small, regulatory bodies, and vested interests interact in setting fees and policies

• Language: English
• Publisher: Academic Press
• Release date: Oct 22, 2013
• ISBN: 9780124047365

Gianluca Mattarocci

Winner of multiple research awards for his investigations in banking and finance, Gianluca Mattrrocci has published on subjects as diverse as real estate finance, bibliometrics, and hedge funds. His work on rating agencies derives from his investigations of the Italian banking industry and their portfolios.

Book preview

The Independence of Credit Rating Agencies

How Business Models and Regulators Interact

Gianluca Mattarocci

Foreword by

Kam C. Chan

Table of Contents

Cover image

Title page

Copyright

Dedication

Foreword

Acknowledgements

List of Tables

List of Figures

Introduction

Chapter one. Rating Agencies and the Rating Service

1.1 Introduction

1.2 The Rating Service

1.3 Rating Service Users

1.4 Conclusions

Chapter two. Rating and Financial Markets

2.1 Introduction

2.2 The Impact of New Ratings on Issuers and Issues

2.3 The Impact of Rating Changes on Issuers and Issues

2.4 Regulation in the Rating Sector

2.5 The Great Financial Crisis and the Role of Rating Agencies

2.6 Conclusions

Chapter three. The Rating Market

3.1 Introduction

3.2 History of the Rating Industry

3.3 Entry Barriers for Newcomers

3.4 The Current Rating Market

3.5 The Evolution of Competition in the Rating Market

3.6 Conclusion

Chapter four. Economic and Financial Equilibrium of Rating Agencies

4.1 Introduction

4.2 Balance Sheet

4.3 Income Statement

4.4 Cash Flow Statement

4.5 Conclusions

Chapter five. Rating Agencies’ Pricing Policies

5.1 Introduction

5.2 Pricing Policies for Information Providers and Rating Agencies

5.3 Rating Agency Fees

5.4 Issuer and User Fee Models

5.5 Pricing Policies for Issuer and User Fee Models

5.6 Conclusions

Chapter six. Organizational Structure and Rating Agency Independence

6.1 Introduction

6.2 Ethical Codes

6.3 Information Flows and Monitoring Methods

6.4 Legal Status and Ownership Concentration

6.5 Group Affiliation

6.6 Public Intervention

6.7 Conclusions

Chapter seven. The Economic Independence of Rating Agencies

7.1 Introduction

7.2 Customer Relationships for Rating Agencies

7.3 Measuring Economic Independence of Rating Agencies

7.4 Measuring Portfolio Concentration for Rating Agencies

7.5 Conclusions

Conclusions

Appendix

Details About Rating Fees Policy Adopted by Agencies

References

Index

Copyright

Academic Press is an imprint of Elsevier

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First edition 2014

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Dedication

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They are forever near

For their love lives on in memories

Our hearts hold dear

Foreword

Kam C. Chan, Ph.D., CFA

Leon Page Chair of Finance and University Distinguished Professor, Western Kentucky University, USA

When I was approached to review a credit rating book manuscript by Professor Gianluca Mattarocci last year, I had in mind that any book in this area needed to be globally relevant and based on strong economic principles. Now the book The Independence of Credit Rating Agencies: How Business Models and Regulators Interact is in print and I am pleased that Professor Mattarocci’s book exceeds my expectation by a large margin.

His book is perhaps the only book that discusses the rating agency industry and elucidates the secrets of operational details of credit rating agencies. It is based on strong academic research and yet offers many insider institutional details. It contains a detailed exposition of the credit rating agency industry with a global emphasis. The coverage of non-US credit agencies and their respective markets is excellent. The book is also very timely, given the recent European credit crisis and the US subprime crisis. The book will definitely help central bankers, regulators, academics, and any interested individuals to better understand credit rating agencies. Most importantly, during the crises, popular media and government officials unselectively blamed rating agencies for what they did or did not do. Professor Mattarocci’s book provides a behind the scenes look into how credit agencies operate and helps us to understand why rating agencies chose what to do or what not to do.

Today, credit rating is important in serving many economic functions, such as providing information to the public and helping government and business to raise capital. However, potential conflicts of interest and their business practices cloud their independence and the reputation of the industry. Professor Mattarocci’s book offers us a strong background about the industry. It is a special scholarly book on credit rating. Everyone who is interested in the topic should read this book.

Acknowledgements

The book has benefited greatly from comments given by all the anonymous reviewers who evaluated the first draft of the work. The quality of the current version of the book will be significantly lower without the independent and high-quality review service provided by all these academics.

Special thanks to Alessandro Carretta, University of Rome Tor Vergata, for his support since the development of the research idea, and to John Doukas, Old Dominion University, for his outstanding advice in refining and finalising the research project. I am also grateful to Scott Bentley, Melissa Murray and all Elsevier’s staff for how they professionally managed the review and the publication process of the volume.

Last but not the least, special thanks to Kam C. Chan, Western Kentucky University, for the foreword to the book.

List of Tables

List of Figures

Gianluca Mattarocci

Introduction

Rating agencies are information providers that reduce information asymmetry by judging the quality of an issue or issuer (Ebenroth and Dillon, 1993). In doing so, they can increase transparency in financial markets (Cowan, 1991). However, it is only an opinion based on information available at the time of the analysis and does not imply any obligation for the evaluator if the judgment is not consistent with the issuer or issue’s real risk exposure (Krahnen and Weber, 2001). This service is useful if the rating agencies are more skilled than the market in collecting, interpreting, and summarizing available information (Goh and Ederington, 1993). However, if this is the case, the market cannot directly assess the quality of the ratings, with such assessments typically based on the accuracy of ratings issued in previous years (Kuhner, 2001).

At present, supervisory authorities frequently use rating judgments to overcome certain problems in monitoring financial intermediaries and markets: For the first type of supervised entities the rating represents a measure of the risk of the lending portfolio, while for the latter the rating is used to define constraints on portfolio management choices in the asset management industry or delimit the investment opportunities of less financial skilled individuals. The current regulatory framework uses the rating judgments to control banks, insurance companies, other financial intermediaries, listed firms and, more generally, other investment vehicles (Cantor and Parker, 1996).

During the last century rating agencies assumed a primary role in the financial markets, and only for extraordinary events (such as Enron) were they not able to correctly evaluate the risk exposure related to an issuer or issue due to the complexity of the entity evaluated (Sinclair, 2003). The current financial crisis reveals the limits of the evaluation procedure adopted by rating agencies, such as the scenario where judgments based on new information cannot be revised on time (Langhor and Langhor, 2008). Rating industry misjudgments are more frequent in certain business sectors, and structured finance products tend to be more frequently misevaluated during crises (Benmelech and Dlugosz, 2009). Many issues have been downgraded directly from investment-grade to junk bonds, demonstrating the limits of rating agencies in predicting and understanding the default risk related to complex financial products (Coval, Jurek, and Stafford, 2009). Errors repeated by the main rating agencies lead to loss in investor confidence in their service, with a greater impact on agencies that adopt an issuer fee model, and have higher risk of collusion with the evaluated entities (Coffee, 2004).

Nowadays investors are worried about the business models adopted by the rating agencies and interested in understanding the rating procedure adopted and the main drivers of their annual income. The main concern about the rating agency business is that it allows a risky sector, structured finance, to have a greater role in determining overall annual income of the rating agency (Partnoy, 2006): Because the evaluation procedure is less accurate for such complex types of financial instruments, a rating agency focused too much on this sector is less useful in reducing information asymmetry in the financial market.

Moreover, critics of rating agencies question their independence with respect to the main market players (Utzig, 2010), which are generally those customers that request the most services from a rating agency. The issuer fee model is frequently criticized in favor of the user fee model, currently adopted only by small to medium-sized rating agencies that can ensure a degree of independence in the evaluation procedure (White, 2010).

The current financial crisis demonstrates some limits of the current supervisory process that are regarded as among the causes of the systemic crisis (McVea, 2010). Since their inception, supervisory authorities have had opportunities to make direct or indirect intervention in the rating markets: The first method allows direct control of the maximum number of agencies authorized and their evaluation procedures, while the latter assumes that the market is able to efficiently self-regulate itself. Even if the rating market is not too competitive with the main entry barrier being a reputational requirement (Guttler, 2005), the supervisory authorities of almost all countries have adopted a market-oriented approach in which the only direct control applied to the market is represented by accreditation principles that all rating agencies must respect to be recognized for monitoring purposes (Lucas, Goodman, and Fabozzi, 2008). To create other incentives for offering high-quality service to the market, the supervisory authorities periodically publish information about the quality and affordability of the rating judgments defined by different agencies (Committee of European Securities Regulators, 2004).

The USA was the first country to adopt this supervisory approach, with the US Securities and Exchange Commission (SEC) in 1975 defining the criteria for a nationally recognized statistical rating organization (NRSRO). In recent years, the same approach has been adopted in Europe, where the Basel Committee has defined comparable requirements for rating agencies to be recognized as external credit assessment institutions. The main aspects considered in identifying higher-quality standards of service are quality and accuracy of judgment and the evaluator’s independence from different types of stakeholders (Champsaur, 2005).

In the literature, the quality of service offered for different counterparties and financial instruments is normally measured by considering the rating prediction’s accuracy, the timing of judgment revisions when new information becomes available, and the most frequent types of errors committed by each rating agency (e.g. Cheng and Neamtiu, 2009). Regulators note that, for supervisory purposes, transparency must also be taken into account: If only investors are able to understand the meaning and main reasoning behind a judgment, the service may be considered an instrument to reduce information asymmetry in financial markets (Goodhart, 2008).

The degree of independence considers both organizational and economic features. Only a deep analysis of the business strategy adopted by each rating agency allows an evaluation of the impact of business choices on judgmental independence. Analysis of economic features requires information about