31 October 2011

Bruegel: Rate expectations - what can and cannot be done about rating agencies

Nicolas Véron writes that CRAs have been under the spotlight since the beginning of the current financial crisis. Although they failed in their assessment of US residential mortgage-based securities in the mid-2000s, investors generally consider them useful to help form their views on credit risks.

The global market for credit ratings is very concentrated, ostensibly as a consequence of high natural barriers to entry. All three leading rating agencies have headquarter functions in the US, but there is no compelling evidence that this has created an analytical bias.

Tighter regulation of rating agencies can be envisaged but is unlikely to have a material positive effect on ratings quality. Better standardised public disclosures on risk factors by issuers are the most promising avenue for future improvements in credit risk assessments.

Rating Agencies

(CRAs) are prominent participants in the assessment of credit risk by financial markets. They determine and publish credit ratings, which represent the CRAs’ opinions on issuers’ relative probability of default. The market for credit ratings is currently dominated in most western countries by three players:

• Standard & Poor’s (S&P) is a division of the McGraw-Hill Companies, a US-based media group whose ownership is dispersed (the largest shareholder is Capital Group, with 12 per cent of shares);
• Moody’s Corporation is an autonomous US-based listed company with dispersed owner-ship (the largest shareholder is BerkshireHathaway, with 12.5 percent of shares);
• Fitch Ratings, a division of the Fitch Group which is jointly owned by Fimalac, a Paris-based listed investment vehicle (60 per cent of shares), and the US-based Hearst Corporation (40 per cent of shares)

Other notable rating agencies include AM Best (US-based, specialised in the insurance industry); Egan Jones (US); Kroll Bond Rating Agency (US); the ratings unit of Morningstar (US); Dominion Bond Rating Service (Canada); Japan Credit Rating Agency (Japan); Rating & Investment Information (Japan); and Dagong Global (China).

However, their volumes of activity are dwarfed by those of the ‘big three’. CRAs rate different types of issuers or issuances. For example, Fitch reports that in 2009-10 it rated around 6,000 financial institutions, 2,000 non-financial corporates, 100 sovereign states and 200 territorial communities, 300 infrastructure bond issuances, 46,000 US municipal bond issuances, and 8,500 structured product issuances. A simplistic but common way of segmenting the market is between sovereign ratings, corporate ratings, and structured credit ratings.

Full paper

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