Why Competition May Not Improve Credit Rating Agencies
Competition usually creates better products and services. But when competition increased among credit rating agencies, the result was less accurate ratings, according to a study by HBS professor Bo Becker and finance professor Todd Milbourn of Washington University in St Louis. In our Q&A, Becker discusses why users of ratings should exercise a little caution. Key concepts include:
- Competition in credit ratings forces raters to favor issuers. This is contrary to the interest of those who rely on ratings to make investment decisions or to regulate.
- There are 10 nationally recognized statistical ratings organizations. The big 3 are Fitch, Standard and Poor's (S&P), and Moody's.
- Fitch used to be much smaller, but over the past decade has become a peer of S&P and Moody's.
- Becker and Milbourn used the appearance of Fitch to test for the effect of competition on corporate bond ratings.
- Policymakers should proceed cautiously when trying to increase competition among raters, and be aware of the potential drawbacks.
- If you really want to know the value of a security, there is no shortcut to doing the work yourself.
In the run-up to the global financial crisis, credit rating agencies gave high marks to such risky financial vehicles as collateralized debt obligations, which few people understood. It has been argued that these ratings misled investors as to the safety of those investments, and that this contributed to the financial turmoil that followed.
This performance has come under tremendous scrutiny by lawmakers and regulators, who are debating ways to reform the ratings industry. One prominent suggestion: increased competition.
But recent research from Harvard Business School questions whether more competition is really the right medicine.
"Competition in the ratings industry has been increasing, and there have been calls for yet more competition. Whether competition is likely to reduce quality or improve it has been unclear," says HBS professor Bo Becker, an expert on bank finance and debt markets.
"These findings throw some doubt on the policy that has been pursued pretty much unanimously by decision-makers in Washington, D.C. to increase competition among raters."
Credit rating agencies provide an assessment of the creditworthiness of a corporation or security, based on the issuer's quality of assets, existing liabilities, borrowing history, and overall business performance. Investors depend on the ratings to predict the likelihood of default on financial obligations and the expected repayment in the event of default.
Becker's recent study with Todd Milbourn, a professor of finance at Washington University in St. Louis, tested the potential problem of raters that compete for business favoring the issuers and providing less reliable ratings. Their HBS working paper "Reputation and Competition: Evidence from the Credit Rating Industry" [PDF], describes how recent increases in competition among raters led to "friendlier," poorer-quality ratings.
As Becker explains, "The related theory goes back to the early 1980s (especially to an influential paper by economists Benjamin Klein and Keith Leffler) and is well known among fellow economists, but it has not been tested much. Whether competition improves or reduces quality depends on whether it forces the raters to work harder to please the investors who are the ultimate users of ratings, or the issuers that pay the bills."
This puzzle matters not least, Becker continues, because regulation has aimed to increase competition among raters ever since the Enron debacle. "As researchers we feared that increased competition may have detrimental effects in this setting."
In our e-mail Q&A, Becker discusses the value of credible and accurate credit ratings; how the research was conducted; and what the findings mean for business leaders, raters, and policymakers.
Martha Lagace: How important are trustworthy credit ratings in the financial system? Could you give us some background?
Bo Becker: Credit ratings have been around a long time. They are basically third-party opinions about the credit-worthiness of a firm or a security. Over the past decades, the financial system has come to rely more and more on such ratings. For example, many institutional investors are legally obliged to hold only securities of some minimum rating, or may have to hold larger reserves when investing in bonds of lower ratings. Ratings are also used in private contracts, for example to define the investment objectives of bond mutual funds.
Ratings are a concise and well-understood metric of credit quality. Ratings firms spread this information, which might be hard for individual investors to collect, analyze, and verify on their own, broadly. Having this type of standardized information freely available to all investors is invaluable for fixed income markets.
Q: As you note, there are three parties involved in this landscape: ratings agencies, firms, and investors. What are agencies' revenue models and their incentives to produce credible and accurate ratings? And what fault lines do you see in this process?
A: Three different revenue models have been tried or proposed for ratings firms. Currently, issuers pay the raters for their work. This "issuer pays" model has the obvious risk of generating pressure to be friendly toward issuers, especially issuers that generate a lot of ratings business (e.g., they have a lot of outstanding debt and issue many bonds).
Historically, raters tended to be financed mainly by investors (the "investor pays" model). This model is used currently by a few of the smaller raters, but it has two main drawbacks. First, it relies heavily on the ability to enforce property rights to information that is very easy to spread. Second, it precludes wide sharing of the ratings—if they are made public for free, why would investors pay for them?—and this means regulation and legislation relying on ratings becomes much harder to implement.
The third type of model, which I have seen proposed recently, is some form of fixed payments (called "bond pays"). Some fixed fee is charged for bond issuance and used to finance ratings. Issuers have no choice but to pay the fee, and are not allowed to choose the rater. By severing the link between issuer and payment, this is supposed to limit potential pressure for favorable ratings. This model has not really been tested, and is probably difficult to implement. The largest issue is how to assign ratings tasks to firms.
There are currently 10 nationally recognized statistical ratings organizations (NRSROs), which is the classification used by the Securities and Exchange Commission for a firm whose ratings can be used to satisfy legal requirements. Three of these firms—Fitch, Standard and Poor's (S&P), and Moody's—are much larger and have fuller coverage of the universe of investable securities, than the others.
Q: Why has competition led to poor ratings quality? Could you tell us more about your findings?
A: Fitch used to be much smaller than S&P and Moody's, but has become a peer over the last decade or so. We use the appearance of Fitch as a way to test for the effect of competition on ratings. When Fitch has a higher market share in issuing ratings for the securities of a particular industry, S&P and Moody's face more competition, and this is what we study. We looked exclusively at corporate bonds (there are no structured products, mortgage-backed securities, etc., in our sample).
We find that stronger competition leads to three things:
First, ratings move toward the triple-A end of the spectrum. This is true for both firm and bond ratings. Approximately one bond in seven or eight sees a higher rating when Fitch has a higher market share by 0.1.
Second, ratings are less correlated with bond yields. In other words, they appear less informative.
Third, firms who get downgraded when competition has gone up see big equity price drops, suggesting that they have failed to reach a very low bar indeed, making the news particularly bad.
The main concern about these findings is that Fitch might have grown their share of the ratings in an industry at times when some of the changes we observe might have happened anyway, regardless of competition. In particular, perhaps Fitch wins more business in industries where ratings are improving. This appears unlikely in practice. Issuers tend to ask more raters for their opinion when they have a hard time getting the rating they would like. This has led to a higher Fitch presence among firms with poor ratings. This tends to obscure our first finding, and when we control for this, the effect of competition is, if anything, larger.
Q: People often assume that competition leads to better products and services. Yet you see competition as more nuanced. What role would you like competition to play going forward?
A: What is a better rating? To an issuer, it's a AAA rating. To an investor who holds a bond, it's a rating that is never reduced. To potential buyers of the bond, it's a rating that accurately reflects default probabilities and that is comparable across issuers and industries. Competition will make ratings better to at least some of these interested parties, but not necessarily to all.
Our results imply that competition in credit ratings forces raters to favor issuers. This is contrary to the interest of those who rely on ratings to make investment decisions or to regulate.
These findings throw some doubt on the policy that has been pursued pretty much unanimously by decision makers in Washington, D.C. to increase competition among raters. There are, however, potential advantages to competition unrelated to what we find about falling ratings quality. For example, having more raters gives the SEC more leeway to ban or punish a rater, because the SEC can do it without debilitating the financial markets.
Q: How can business leaders improve the quality of their own work with ratings agencies and investors?
A: For users of ratings, a bit of caution is in order. Third-party ratings are produced by profit-making firms, and that system, which has generally worked very well, is not flawless. If you want to really know the value of a security, there is no shortcut to doing the work yourself. Nevertheless, ratings still fulfill a very valuable function. It is worth keeping in mind that the effects we find are modest. Ratings remain a very informative summary of credit-worthiness.
Remember also that while the ratings of structured products have been widely criticized, corporate ratings have held up much better during the recent crisis. This means that for firms issuing fixed income securities, ratings are still an invaluable tool.
Q: How should raters and policymakers respond?
A: Policymakers should proceed cautiously when trying to increase competition among raters, and be aware of the potential drawbacks. Modest competition may allow raters to think more about their long-term standing and less about winning business today. However, unrelated to what we find about falling ratings quality, there are other potential advantages to competition. For example, as I mentioned above, with more raters the SEC has more leeway to ban or punish a rater without debilitating the financial markets. This type of regulatory discipline might be valuable going forward, and may require having a fair number of ratings firms.
Q: What's next for you?
A: There are many fascinating questions about corporate finance right now. I am currently working on projects about bank finance and debt markets.