Study Report on Credit Rating Agencies
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Transcript of Study Report on Credit Rating Agencies
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Credit Rating Agencies: An Alternative Model
Pragyan Deb and Gareth Murphy
November 2009
Abstract
We explore the conflict of interest which arises in the credit ratings industry due to thecurrent issuer-pay model. We argue that the most efficient way of aligning the incentives ofrating agencies is to return to an investor-pay system. Careful analysis of the reforms currentlybeing discussed suggests that, by themselves, they will have insufficient impact if the currentissuer-pay model is maintained.
While a return to the pre-1970s investor-pay model would solve the conflict of interestproblem, the issue of free-riding amongst some investors is likely to result in insufficient rev-enues for the rating agencies. We argue that although free-riding is a problem, the increasinguse of ratings by institutions coupled with the rise in the speed of information diffusion andpredominance of electronic trading venues over the last few decades would ensure that thereare investors willing to subscribe to ratings. This investor-pay revenue could be supplementedby a government subsidy to ensure that sufficient resources are available to the rating agencies.
To fund the government subsidy, we propose that a small tax would be levied on issuers
or at the point of issue. A limited number of rating licenses which provided a right to ratewhich would be auctioned (just like 3G auctions) and the auction winners would be entitledto a portion of the tax pool which is paid in arrears and linked to the share of the investor-paymarket that they manage to achieve.
Such a system would align the incentives of the rating agencies with investors, would ensurea commercially viable ratings agency industry and would have negligible impact on primaryissuance markets.
Keywords: Competition, Reputation, Financial Regulation, Auction, Industrial Organisation
JEL Classifications: C7, D4, G2, K2, L1, L9
London School of Economics and Financial Markets Group, E-mail: [email protected]
Bank of England, E-mail: [email protected]
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1 Introduction
The credit rating industry aims to offer investors valuable information about firms in need of
financing. Due to asymmetric information between the firms and the investors, credit ratings
often have a pivotal impact on the firms financing outcomes. However since the early 1970s,
rating agencies have relied on an issuer-pay model, creating a conflict of interest - the largest
source of income for the rating agencies are the fees paid by the very firms that the rating
agencies are supposed to impartially rate.1 This tempts rating agencies to rate better than what
fundamentals suggest, as many have pointed out during the recent subprime crisis.
In this paper, we explore the conflict of interest which arises in the credit rating industry due to
the issuer-pay model. The rest of this section reviews the current business model of rating agencies
and summarises the academic literature highlighting the problems with the current structure.
Section 2 examines the proposals currently being discussed to reform the rating agencies, and
suggests that by themselves, they will have an insufficient impact if the current issuer-pay model
is maintained. In Section 3, we propose an alternative structure for the industry - an investor-pay
model, supplemented by a government subsidy to ensure sufficient resources are available to the
rating agencies. Section 4 concludes.
1.1 Business Models: Past and Present
Before the 1970s, the ratings industry operated under an investor-pay model. Investors subscribed
to ratings released by the agencies, and these subscription revenues were the main source of income
for the rating agencies. However, owing to the public good nature of ratings and the increase in
free-riding due to the spread of the photocopier, rating agencies switched to the current issuer-pay
model.
In 1970s Moodys and Fitch switched to the issuer pay model with S&P following a few years
later2. As the market stands today, S&P and Moodys (which account for around 80% of the
market) rate and make public all SEC-registered firms, whether the rating is requested or not 3. Ifthe issuer does not request a rating, the rating agency issues a rating based on publicly available
information. If issuer requests a rating, it pays the rating fees and provides the rating agency
with private information about the firm. Typically an issuer gets a higher rating after having
solicited a rating from a rating agency.4
1SEC, 2008, p.92S&P switched to issuer pay model for municipal bonds in 19683FITCH only does solicited ratings4There are 2 possible explanations for this -
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The combined revenue from ratings of the big-three rating agencies - S&P, Moodys and
FITCH stood at US$3.7 billion in 2008. This, when compared with total rated bond issuance
of US$3.9 trillion5 implies average revenue from rating in the order of 10bps. This is important
for calibrating the subsidies in the investor-pay model outlined in section 3 since it suggests that
any tax imposed to fund the subsidy is likely to be small and thus have a potentially negligible
impact on the market.
Name Comments
Standard & Poors Ratings Services Largest playerMoodys Investors Service, Inc. Second largest after S&PFitch, Inc. Much smaller, but part of big-threeA.M. Best Company, Inc. Specialises in the insurance market
DBRS Ltd. Focus on CanadaEgan-Jones Rating Company Investor-payJapan Credit Rating Agency, Ltd. Focus on JapanLACE Financial Corp. Investor-pay, specialises in financial institutionsRating and Investment Information, Inc. Focus on JapanRealpoint LLC Specialises in structured finance market
Table 1: NRSRO designated rating agencies in US, as of September 2008
Apart from the big-three rating agencies, seven other rating agencies are recognised as Na-
tionally Recognized Statistical Rating Organizations (NRSROs) in the US. However, they are
comparatively tiny and they restrict their activities to particular market segments. An interest-
ing trend in the last few years has been the emergence of investor-pay rating agencies, such as
Egan-Jones Rating Company, LACE Financial and Rapid Ratings. Furthermore, as Firgure 1
shows, Moodys issuer-pay revenues fell from 89% of total revenues in 1999 to 72% in 2008. These
trends indicate that the investor-pay business model may be viable, although the issuer-pay model
is by far dominant and remains the main source of revenue for rating agencies.
1.2 Problems with the current system
The current issuer-pay system creates a conflict of interest for the rating agencies since their main
source of revenue, i.e the rating fee, comes from the issuers that the rating agencies are supposed
to impartially rate. An analysis of the annual reports of the big-three rating agencies suggests
that issuer-pay rating revenues account for roughly 84% of Moodys total revenues (average of
last 5 years), while the corresponding amount for S&P and FITCH is 72% and 85% respectively.
Sample selection bias - only firms with favorable information choose to solicit ratings.
Rating agencies are biased and improve the rating if they get fees.
5Both figures were down sharply due to the subprime crisis. In 2007, ratings revenues stood at US$4.9 billion,while bond issuance was US$4.7 trillion.
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86% 89% 86% 87% 83% 81% 80% 82% 83% 81% 72%
0
500
1000
1500
2000
2500
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
US$ million
Other Revenue
Ratings Revenue
Figure 1: Moodys ratings revenue (issuer-pay) has fallen over time
While rating agencies have long claimed that this conflict is unlikely to bias their ratings out of
concern for their reputation, the recent sub-prime crisis has clearly shown that this is not the
case.
Every rating agency has its own published fee structure, but there is widespread use of ne-
gotiated rates for frequent issuers. In general, frequent, large issuers tend to establish long term
relationships with the rating agencies, making the task of regulating the relationship much more
difficult. Thus, even if issuers are forced to pay rating agencies for initial analysis,6 it is unlikely
to ensure proper incentives for rating agencies when the issuer-rater relationship is viewed as a
long term relationship as opposed to a one-off transaction.Since the crisis, a growing body of research has highlighted the weaknesses of the current
model. Rochet, Mathis, and Mc Andrews (2008) show that reputational concerns are not enough
to solve the conflict of interest problem. In equilibrium, rating agencies are likely to behave laxly,
i.e. rate bad projects as good and are prone to reputation cycles. While Rochet, Mathis, and
Mc Andrews (2008) look at the conflict in the context of a monopolistic rating agency, Camanho,
Deb, and Liu (2009) show that the often sighted solution of introducing more competition is likely
6as proposed under the Cuomo Plan
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to aggravate the conflict further and lead to increased ratings inflation.
This result stems from the fact that increasing the number of rating agencies with the aim of
increasing competition, reduces an individual rating agencies reward from maintaining reputation.
If the overall size of the ratings market remains the same, then with increased competition, each
rating agency has a smaller share of the market. In such a situation, the benefits of maintaining
reputation (and giving honest ratings) falls and ratings inflation increases. Camanho, Deb, and
Liu (2009) show that in general, moving from a monopolistic to a duopolistic setting will increase
ratings inflation and aggravate the lax behaviour of rating agencies. Becker and Milbourn (2008)
measure empirically the relationship between competition amongst rating agencies on reputation
building. They show that increased competition7 leads to ratings inflation and less informative
ratings. Thus, reputational concerns are not sufficient to discipline rating agencies.
It is the case that this result depends critically on the assumption that the overall market
size remains the same. However, increasing the size of the ratings market by requiring issuers to
approach multiple rating agencies is also not likely to help. Bolton, Freixas, and Shapiro (2009)
show that with multiple ratings, issuers have more opportunity to rate-shop8 and in the presence
of naive investors,9 monopoly is superior to duopoly in terms of total ex-ante investor welfare.
Therefore, in order to enhance competition, if we allow for a large number of rating agencies,
more and more investors will find it difficult to infer rate-shopping and effectively the fraction
of naive investors in the market would rise. At the same time, with more rating agencies, theissuers ability to rate shop would increase thereby decreasing ex-ante investor welfare. Skreta
and Veldkamp (2008) do not consider the strategic behavior of rating agencies but explore the
interaction between rate-shopping, complexity of the security10 and competition. They show that
the intensity for rate-shopping increases with the complexity of the security and competition
between rating agencies amplifies this problem.
Both these papers argue for a ban on rate-shopping. However, such a ban11 coupled with
enhanced competition in the form of larger number of rating agencies will decrease the market
size for each rating agency, make existing clients more valuable and thus reduce their incentive
to maintain their reputation. Therefore, increasing the number of players while banning rate-
shopping is likely to aggravate ratings inflation as highlighted in Camanho, Deb, and Liu (2009).
7in the form of increased market share for FITCH8get multiple ratings from different rating agencies and make public only favourable ratings9investors who are unable to infer the extent of rate-shopping.10a key factor for structured products11which will be very difficult to enforce given the long term relationship between the issuer and the rating agency
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2 Proposed Reforms
There exists general consensus in policy circles on the need to strengthen the regulation of credit
rating agencies, including measures to promote robust policies and procedures that manage and
disclose conflicts of interest, differentiate between structured and other products, and otherwise
strengthen the integrity of the ratings process.12
However most of the reforms currently being discussed attempt to increase regulatory oversight
and disclosure norms in order to tweak the current issuer-pay system and make it more transparent
without attempting to eliminate the inherent conflict of interest outlined above. In what follows,
we look at some of the major reform proposals and argue that, by themselves they will have an
insufficient impact. However, when combined with an investor-pay model (as proposed in Section
3), they are likely to be highly effective in enhancing transparency and efficiency in the ratings
industry.
We look at the following reforms proposals -
1. Lowering Barriers to Entry
2. Holding Rating Agencies Legally Liable for their Ratings
3. Taxpayer Funded Credit Rating Agency
4. Ban on Rate-Shopping and Consulting Services
5. Make Ratings more Informative
2.1 Lowering Barriers to Entry
Moodys and S&P have dominated the credit ratings industry for years and together with FITCH
control around 95% of the market. The ratings industry has large and often prohibitive barriers to
entry. While some of these barriers such as reputation, scale economies and network effects13 are
inherent in the business, others are a result of regulatory restrictions and insufficient disclosure
requirements.
It has been suggested that if information is made more widely available, it might reduce entry
barriers to this industry, increase competition and serve to alleviate the incentive problems in this
industry. Typically, in the case of solicited ratings, issuers provide private information to rating
12US Department of the Treasury - Financial Regulatory Reform: A New Foundation (2009)13investors desire for consistency of rating categories across issuers limits number of players
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agencies. If this information is revealed to the wider market, then it could incentivise other players
such as insurance, pension and mutual funds, brokerages etc. to use this information in their own
internal reports and investment decisions. They can then act as investor-raters making their
reports public, providing the wider investor community with an additional source of information
- a de-facto rating . This will enhance the level of competition in the ratings industry.
However, as noted earlier, merely increasing competition in the ratings business is likely to be
counterproductive. However, in this case, since the funds and brokerages undertaking research
have a stake in their own ratings, they will not have the same conflict of interest that plague
the rating agencies. In essence, it will be similar to having incumbent rating agencies have a
stake (legal or economic) in their ratings. However, the potential for market manipulation by the
investor-raters needs to be taken into account. For example, investor-raters may be tempted to
sell their stake just before a downgrade or issue biased ratings in order to move the markets in a
particular direction.
At this stage, a distinction needs to be drawn between brokerages, which are likely to have
much wider coverage but less stake in their reports14 and mutual funds which would be much
more selective on their coverage, but are likely to have a much larger stake in their reports.15 In
general, wider coverage would mean having a lower stake in their reports. Thus, if the investor-
raters indeed morph into de-facto rating agencies and cover most asset classes, their stake in their
reports would become marginal and they will end up with incentives very similar to the incumbentrating agencies.
Even if these issues are resolved, we have another potential problem. Issuers may not be willing
to make their private information public. While they may be willing to disclose the information
to a rating agency in confidence, they may undermine their competitive position if the same
information is made available to the public and thus their competitors.
Thus we might get 2 different cases. In the first case, if disclosure norms are not mandatory,
then pure rating agencies will have access to additional private information provided by the issuers
vis-a-vis investor-raters. Thus investors have to decide between 2 different kinds of rating agencies
Pure Rating Agencies, that face a conflict of interest and potentially issue biased ratings,
but have access to private information of the issuers.
Investor-Raters, that face the right incentives, but are informationally constrained.
14which is primarily used as a marketing product15assuming their investment decisions are verifiably based on these reports
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Thus, this kind of a mechanism will be of limited benefit and will make the job of the investors
much more difficult.
The other alternative is mandatory disclosure of all private information. However, such a
policy may not be in the interest of the issuers. In the case of corporate issuers, it risks exposing
their company secrets to competitors. In the case of structured products, complete disclosure
would result in lower profits and thus decrease the incentive to innovate. The gains from financial
innovation will be capped because full disclosure will allow competitors to copy the product very
quickly. Over time, this may stifle innovation and may have detrimental welfare consequences.
Furthermore, such blanket disclosure requirements will be very hard to implement and are
likely to create inefficient market structures. For example, if disclosure requirements are imposedon one part of the market (for example on exchange traded products), then it would encourage
issuers to go for privately placed OTC instruments. Over time, the OTC market will expand and
end up becoming the dominant part of the system.
2.2 Holding Rating Agencies Legally Liable for their Ratings
Currently, credit ratings are treated as opinions and thus rating agencies cannot be held legally
liable for their ratings which are protected under free speech. However, if rating agencies are
made liable for the quality of their ratings,16 it would go a long way in resolving the conflict ofinterest. Currently, the only factor restraining rating agencies is the concern for reputation, but
if this channel is strengthened by forcing rating agencies to have a legal or financial stake in their
ratings, rating agencies would no longer find it profitable to inflate ratings. This would have the
same effect as having investor-raters in the market (see section 2.1)
However, given the nature of the ratings industry, it would be very difficult to force rating
agencies to have a stake in their ratings. Given the capital structure of rating agencies and the
size of the market that needs to be rated, a financial stake in their ratings is not feasible. 17 While
a financial or a legal penalty is possible in the event of ex-post poor quality rating, it would be
very hard to implement.
For the system of penalties for poor ratings to work effectively, it would require authorities
(regulatory or judicial) to be able to distinguish between poor ratings arising out of rating agency
bias or bad luck. If it is the former, then a penalty would be warranted, but in case of the latter,
the penalty would lead to inefficiencies.
16like auditors17unlike banks and other financial institutions, rating agencies do not hold any capital. Hence the US proposal
for joint lability
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It is very unlikely that authorities would be able to make such a distinction with relative
certainty, making a blanket penalty the only feasible option. But a blanket penalty every time
the quality of ratings falls below a threshold would do little to solve the incentive problem of
rating agencies.
Such a blanket penalty would only serve to make rating agencies excessively conservative.
This is because rating agencies, fearing the penalty would prefer to err on the side of caution and
give lower ratings. Therefore such a proposal would essentially replace the upward bias in ratings
with a conservative bias, leading to less informative ratings and possible capital misallocation.
Furthermore, the US joint liability proposal18 would make the entry barriers to the industry
even more prohibitive. This is because under such a system, any new potential entrant maybecome liable for all ratings issued by other players. As James H. Gellert of Rapid Ratings
International, Inc. puts it,19
Why would one want to become an NRSRO joining a group dominated by three players with
an iceberg of lawsuits looming on their horizon? That would be like swimming towards the
Titanic.
2.3 Taxpayer Funded Credit Rating Agency
A taxpayer funded rating agency would not be driven by commercial motives and thus such an
agency is not likely inflate ratings. Since investors are rational, they will take this into account
and thus the taxpayer funded agency will have perfect reputation.
If the taxpayer funded agency is just as efficient as the private rating agency, it will capture
the entire market. This is because given its perfect reputation and same cost to the issuer as
private rating agency, an issuer with a good project will always prefer to approach the taxpayer
funded rating agency for rating. The only case where an issuer will approach the private rating
agency is when it had a bad project and hopes that the private rating agency will give it a good
rating. But this will be fully anticipated by the market and the private rating agencies rating will
be useless. Thus in this situation, the presence of the taxpayer funded rating agency will lead to
the elimination of private rating agencies from the market.
On the other had, the taxpayer funded rating agency might have a perfect reputation, but it
may be less efficient in identifying good and bad projects. Thus for the investors, the trade-off
18See EuroWeek (2009) and Financial Times (2009b) for details of the US proposals to make rating agenciesjointly liable for their ratings
19See Gellert (2009)
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between private and public rating agency would boil down to a choice between between incentives
and ability. While the taxpayer funded rating agency will give unbiased ratings, it would be less
efficient. On the other hand, the private rating agency would give biased ratings but will be more
efficient at identifying projects.
This system by itself, will not solve the conflict of interest of the private rating agencies.
However, it might have a limited disciplining effect on private rating agencies by setting an upper
limit for ratings inflation. This is because the presence of a taxpayer funded rating agency may set
a lower bound for reputation of the private rating agency. If the reputation of the private rating
agency falls below the threshold, all issuers may approach the taxpayer funded rating agency
(same mechanism as above) and the private rating agency may be eliminated from the market.
2.4 Ban Rate-Shopping and Consulting Services
Rate-shopping refers to issuers approaching multiple rating agencies for rating and selectively
disclosing only those ratings that are favorable. Often issuers play one rating agency against the
other in order to get favourable ratings. To quote former chief of Moodys, Tom McGuire,20
The banks pay only if [the ratings agency] delivers the desired rating.. . If Moodys and a
client bank dont see eye-to-eye, the bank can either tweak the numbers or try its luck with a
competitor. . .
Furthermore, rating agencies routinely provide creative suggestions to issuers regarding the
design of structured products in order to improve ratings. The recent subprime crisis, provides
clear evidence of this. Instead of being neutral players, rating agencies were working actively
with investment banks on the design of complex securities, such as CDOs and MBS. As a former
Moodys expert in securitization says -
Every agency has a model available to bankers that allows them to run the numbers until they
get something they like and send it in for a rating.
Or, as Chris Flanagan, the subprime analyst at JPMorgan claimed
Gaming is the whole thing. . . Banks were gaming the ratings and designing only the securities
that were blessed by the rating agency.
20New York Times Magazine, Triple-A-Failure, April 27, 2008
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This is of particular concern for complex structured products since small superficial changes
to the asset pool or the nature of the contract can have disproportionate effects on ratings.
Thus, such consultations can potentially amount to data mining,21 severely underling the ratings
methodology.
Given this situation, it has been suggested that requiring rating agencies to disclose all ratings
irrespective of the wishes of the issuers as well as forcing rating agencies to make public any initial
consultation they may have with issuers can put a stop to rate-shopping. However, under the
issuer-pay system, given the complex nature of interaction between the issuers and the rating
agencies, it would be very difficult to enforce such a regulation. As is clear form the opposition of
rating agencies to any such move,22 rating agencies are unlikely to actively cooperate in the imple-
mentation of such regulation. Thus, such a move would require constant regulatory supervision,
making enforcement costly and difficult.
Furthermore, as pointed out in Section 1.2, such a ban would decrease the overall size of the
ratings market (by reducing the incidence of multiple ratings), reducing rating agencies incentives
from maintaining reputation and thus resulting in more ratings inflation.23
2.5 More Informative Ratings
It has been argued that as it stands, ratings do not provide sufficient information to investorsto make informed decisions. The current system of rating buckets are too coarse and provide
insufficient information to investors. The ratings bucket of different rating agencies have different
meanings and they often hide important details such as variance, likelihood of default and/or loss
severity in the event of default. This is particularly true in case of structured products which are
extremely complex and investors need more information to make informed decisions.
For example, under the probability of default based ratings approach (employed by S&P
and FITCH) the rating agency calculates the likelihood of income stream of a CDO tranche
falling short of its contractual value and determines the rating by comparing this likelihood with
historically calculated default probability. Similarly, under the expected loss based approach used
by Moodys, percentage expected losses are calculated and compared with historical benchmark
information. Both models provide an overall expected rating, but hide details regarding the
distribution of losses etc. which are vital for informed investor decision.
21Since every statistical model has some Type II error, i.e. failure to reject a null (high rating) when it is false,the issuer can get the desired rating by repeatedly tweaking the product. Thus through consultations, issuers canensure that their products get a hight rating, even if it is not warranted
22See Watson (2008a) and Watson (2008b)23See Camanho, Deb, and Liu (2009)
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While increasing the information content of ratings is a step in the right direction, the effect
of such a move on ratings bias is uncertain. Under the issuer-pay model, rating agencies will
find it optimal to inflate ratings, even if the content of the rating is more informative. However,
it is possible that more information will make it easier for investors to detect the bias and thus
make it a little less pronounced. But fundamentally, making rating more effective is unlikely
to solve the incentive problems of the issuer-pay model. However, as explained in the following
section, making ratings more informative while switching to the alternative investor-pay model
can mitigate the free rider problem to a large extent.
ProposalIncentive Commercially Rate- Direction of
Aligned Viable Shopping Rating Bias
Current System No Yes Yes InflationLower Barriers to Entry No Yes Yes
Inflation, potentialmarket manipulation
Holding Rating Agencies LegallyLiable for their Ratings
No No Yes Conservative
Taxpayer Funded Credit RatingAgency
Yes Yesa, Nob Yes Inflation
Ban Rate-Shopping & ConsultingServices
No Yes No Inflation
More Informative Ratings No Yes Yes InflationInvestor-Pay Yes No No None
Investor-Pay with subsidy Yes Yes No None
aif taxpayer funded rating agency is less efficientbassume taxpayer-funded rating agency is equally efficient
Table 2: Impact of Proposed Reforms
3 An Alternative Model
The analysis in section 2 suggests that the reforms currently being discussed will be insufficient to
solve the incentive problems inherent in the issuer-pay model. Thus we propose a return to the pre-
1970s investor-pay model. The investor-pay model is the most effective way of aligning incentivesof rating agencies and investors and eliminating the conflict of interest of rating agencies. However,
it is also prone to the problem of free-riding, resulting in insufficient resources for research and
analysis and thus poor quality ratings. As the rating agencies point out, free riding was one of
the main reasons behind the switch to an issuer-pay system in the 1970s.
While it is true that free riding is a big issue, the increasing use of ratings by institutions, cou-
pled with the sharp rise in the speed of information diffusion in the markets and the predominance
of electronic trading venues over the last few decades has increased the speed of price response to
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market events to only a few seconds.24 This is likely to ensure that there are investors willing to
subscribe to a rating agency as opposed to waiting for selected parts of the information to leak
through the market. The delay involved in free riding might be too costly for some investors.
Thus, investors that require ratings information quickly will be willing to pay in order to
avoid delays inherent in free riding. Investors such as large traders and brokerages, pension and
mutual funds, insurance companies and other institutions that have structures in place to act on
the information quickly will be willing to subscribe to the ratings as opposed to free riding and
waiting for the information to arrive with a lag. Given the high speed of information diffusion, the
opportunity cost of waiting is likely to be too high for such investors since the market would have
already moved in response to the ratings information. On the other hand, investors who cannot
trade immediately such as households and small retail investors, will have a low opportunity cost
and they would likely choose to free ride. However, in equilibrium, there would always be some
investors willing to subscribe to the ratings.
In this context, regulation aimed at making ratings more informative25 is extremely important
as it can potentially mitigate the free riding problem to a large extent. Even if investors are able
to learn the broad ratings bracket through free riding, it is unlikely that they will get access to the
necessary details fast enough if they try to free ride. They would need to subscribe to get reports,
access to analysts etc. Thus, as ratings become more and more informative, the opportunity cost
of free riding increases, mitigating the free rider problem to a large extent.
More formally, assume that investors using credit rating for their investment decisions can
choose to be subscribers or free riders. If they choose to be free riders, they do not have to pay
the rating agencies subscription fee (s). However free riding involves a delay and we assume that
the the opportunity cost of free riding for the investor concerned is .
As a modeling device, we assume that there exists a continuum of investors with lying
between a and b. Assuming a continuum of investors makes the model tractable26. Intuitively,
a represents the opportunity cost for a investor who would not act on the ratings information
(and is thus close to 0) while b is the highest possible opportunity cost (representing institutionalinvestors who would trade on rating information immediately).
Thus, each investor decides whether to free ride or subscribe depending on . If > s, then
the investor is better off subscribing to the rating agency as the opportunity cost of free riding is
too high. On the other hand, if < s, the investor prefers to free ride and wait for the information
24[[[[[quote papers on effect of media on speed of information diffusion]]]]]25See section 2.526The result holds for any possible distributional assumptions
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a b
SubscribersFree Ri ers
s
Figure 2: Investor Choice - Free Rider or Subscriber
to arrive with a lag. The fraction of investors subscribing to the rating agency is given by = bsba
.
Note that the fraction of subscribers is a function of the fees charged by the rating agency
and the information content of ratings. As the information content of the ratings increases (i.e. increases), the fraction of subscribing investors rises, thus mitigating the free rider problem.
Also, as the subscription fee falls, the the fraction of subscribing investors rises.
Therefore it is likely that there will always be a fraction of investors () who find it profitable
to subscribe to the rating agencies reports. Assuming a unit mass of investors and a per-subscriber
costs of rating c, the profits of the rating agency takes the following form:
= s c
The problem arises when the fee charged is relatively modest and/or the fraction is small.
In this case the investor-pay system may not generate enough revenues for the rating agencies,
i.e. < 0. In such a situation, the rating agencies will not survive or will be forced to cut costs
and compromise on the quality of their research. To avoid this scenario, it might be necessary to
establish a supplementary source of revenue for the rating agencies.
Such an alternate source of revenue can take the form of a government subsidy. In order
to provide rating agencies with the correct incentives, the subsidy should be proportional to
its subscription revenues. Such a subsidy will incentivise the rating agencies to maximise their
investor-pay revenues, thus aligning incentives. The new profit function becomes
= s c + s
An attractive feature of this structure is that it does not require costly regulatory information
as once the level of subsidy is optimally determined, the distribution of the subsidy amongst the
rating agencies is based on their respective market shares. This market determined distribution
system is much more desirable than the regulator trying to determine the share of each rating
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agency on a case by case basis.
This system is dynamic in the sense that it reflects the markets (investors) best guess about
the relative usefulness of different rating agencies ratings. If a particular rating agency does not
perform up to standards, its market share is likely to fall over time, and with it the subsidy. Thus,
this system provides a market determined measure of performance as opposed to a pre-set metric
which can result in regulatory arbitrage and is open to abuse.
Another big advantage of this system is that it makes rate-shopping much more difficult for
issuers. This is because with an investor-pay system, it is not in the interest of rating agencies
to hide (or not make public) an unfavorable report. Thus, with an investor-pay system, any ban
on rate-shopping will be much easier to implement since rating agencies would themselves have astrong incentive to comply with it.
A potential problem with the above system is that the rating agencies incentives will be
aligned only with fraction of the investors that subscribe to their ratings. If the incentives
of the remaining (1 ) free-riding investors are different, then it might result in a conflict of
interest27. This is particularly true if the differences in incentives are unknown or change in an
unpredictable way, then it might turn out to be a potential problem.
While we address this issue further in section 3.3, at this stage its important to point out
that making credit ratings more informative should mitigate this to a large extent (see section2.5). This is because, even if the incentives of the subscribing and free riding investors are not
perfectly aligned, they are unlikely to be in direct conflict with each other. They might have
slightly different preferences, but it is unlikely that they can gain at each others expense - as in
the case of issuers vs investors where there is a clear and direct conflict 28.
Furthermore, under this system, the capital structure and revenue stream of the rating agencies
are clear and open to scrutiny. Thus, if it would be easy to determine if a particular rating agency
is under the influence of a special interest group. As discussed in section 3.3, other rating agencies,
competing directly for market share, would do all they can to highlight this fact in order to win
over subscribers. Finally, a potent safety feature of this system is that the free-riding subscriberswould always have an option to subscribe to the ratings, thus aligning incentives limiting the
potential damage from misaligned incentives.
27For example, pension funds with a mandate to invest in only AAA securities might want more securities to berated AAA
28For example, a pension fund demanding AAA rated bonds, would still prefer bonds of a higher quality. Theymay prefer the rating brackets to be broadened to increase their scope and scale of operations, but they would stillprefer to invest in bonds that do not default
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3.1 Optimal Subsidy
From the regulatory perspective, determining the actual level of subsidy is not a trivial matter.
Given the revenue stream of the rating agency, the subsidy should be such that the rating agency
at least breaks even. Note that the break-even condition allows the rating agencies to make rea-
sonable profits in order to be viable and able to respond and invest to dynamic market conditions.
We set profits to 0 to simplify the exposition:
= s c + s = 0
or =c
s 1
In order to optimally determine , the regulator needs detailed and accurate information on the
rating agencys costs as well as demand, supply and optimal pricing of the ratings. While this is
possible (as in the case of other regulated industries like electricity, gas, water etc.), this is likely
to impose a heavy burden on the regulator. Furthermore, ever if the regulator could optimally
set , since the subsidy is designed to ensure that the rating agencies break even in equilibrium,
it would deter rating agencies from competing for market share.
Given this problem, we need a mechanism which imposes less informational burden on the
regulator and preserves the incentives of the rating agencies to compete amongst themselves for
investor-pay revenues and market share. In order to ensure the latter, the subsidy should be fixed
a-priori allowing rating agencies to maximise their profit without worrying about an offsetting
reduction in the subsidy. Thus the rating agency should reap the rewards from ex-post increase in
market share arising from improvement in the ratings and overall quality of service, innovation,
cost reduction etc.
Since each rating agency is best suited to determine its own cost structure and expected
revenues, we propose an auction mechanism, similar to the 3G auctions, to determine the
optimal subsidy rate for the rating agencies. Each rating agency determines the minimum level
of subsidy it requires to break even
i =ci
isi 1
If the auction process is properly designed, then the most efficient rating agencies, i.e. the ones
that are confident of getting higher subscription revenues from the investors and have lower costs
will win the auction. After the auction, the rating agencies will continue to compete since the
subsidy is contingent on the investor-pay revenues.
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The auction process would involve giving rating agencies the right to rate and get the subsidy
for a fixed number of years. The optimal period would depend on the length of time the rating
agencies require to recoup their costs and make reasonable profits. Thus, the period would be
a critical factor in determining the attractiveness of the auction process and thus the degree of
competition. For the sake of this exposition, we assume that 5 years is optimal.
Furthermore, in order to maintain the quality of ratings and make the ratings market more
dynamic, we propose repeat annual auctions on a rolling basis. In the annual actions, the rating
agency that has the lowest market share and has completed its guaranteed 5 year period will
have to compete in the auction once again for the right to rate. This will ensure that there
is enough competition in the market and incumbent rating agencies are forced to continuously
compete and maintain best possible rating standards. Thus this mechanism would use the market
to determine and punish the most inefficient rating agency as opposed to having the regulator
measure performance base on a particular metric.
3.2 The Auction Mechanism
A well designed auction is the method most likely to allocate resources to those who can use
them most valuably since it forces business to put their money where their mouths are when
they submit bids.An auction can therefore extract and use information otherwise unavailable tothe government.29 However, it is vital that the auction is properly designed and tailored to the
particular context. We look at the literature on 3G licence auction for motivation on optimal
auction design for the ratings business. Broadly, the optimal auction mechanism should achieve
3 main objectives:
It should allocate the right to rate to the most efficient rating agencies
It should promote competition
It should minimises the subsidy burden
One of the key challenges in designing the auction for the ratings industry is the big advantage
of incumbents30 over potential new entrants. As discussed earlier, the ratings industry is plagued
by barriers to entry, both economic and regulatory. In addition to the large set-up and fixed
costs to entry, incumbents also have the advantage of established customer bases and brand-name
29For example, the successful UK 3G auction yielded about 22.5 billion or 212
% of GNP and resulted in a com-petitive telecom market in the UK
30particularly the big 3 rating agencies - S&P, Moodys and FITCH
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recognition. Thus, in order to make the auction process competitive, it is vital that the auction
design provides sufficient incentives to new entrants.
One of the key parameters to achieve this is the number of licences. Since there are three
dominant incumbents in the market, the number of licences on offer should be greater than three.
Otherwise any new entrant would be deterred from participating in the auction process rendering
it inefficient.31 However, in the context of the ratings industry, given its current structure and
the barriers to entry that already exists, giving out more than three licences, coupled with the
fixed term guarantee to recoup costs, might actually lead to a decline in entry barriers and foster
competition.
The other potential problem with the auction mechanism is that the incumbent rating agenciesmight feel forced to win a new licence in order to avoid a sharp reduction the value of their
previous investments. The proposal to require the worst performing rating agency to participate
in the auction process after the fixed guaranteed term would lead to disruptions and can act as
a disincentive for rating agencies from participating in the auction. However, such a mechanism
is vital to ensure efficiency and continued competition in the ratings industry. The incumbents
disincentive from repeat auctions must be balanced with the need to maintain a dynamic system.32
While the exact length of time a rating agency needs to recoup costs is debatable, some kind of
penalty for poor performance is necessary to maintain market efficiency. In any case, after the
fixed term, the worst performing incumbent rating agency will still be allowed to compete inthe auction process. We believe that the risk of losing the right to rate is no different from
the general penalty for poor performance in the market. Risk is part of any business and rating
agencies are free to take this into account while competing in the bidding process. In principle,
the number of licenses can be changed to reflect the prevailing market conditions
Broadly, we have 3 distinct auction mechanisms:
Simultaneous Ascending Design
equivalent to Second Price Auction
Sealed Bid Auction
equivalent to First Price Auction
Hybrid Anglo-Dutch Design
31For example, the Netherland 3G auction of July 2000 performed poorly because there were 5 licences with 5incumbents, deterring potential new entrants
32Repeat auctions can be made contingent of the market share of the worst performing rating agency fallingbelow some pre-determined threshold. However, such a system risks cartelisation of the industry, with incumbentsnot competing with each other in order to sustain super-normal profits.
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combines element of both
We analyse these 3 types of auctions with a view to see which is best suited for the ratings
industry.
Simultaneous Ascending Design
In the simultaneous ascending auction, or the English Auction, participants bid openly against
one another, with each subsequent bid higher than the previous bid. The auction ends when no
participant is willing to bid further, at which point the highest bidder pays their bid. The
distinguishing feature of this auction type is that the current highest bid is always available to
potential bidders. Thus, in terms of outcomes, its equivalent to the sealed bid, second priceauction. In the context of allocating multiple, equivalent licences, the auction ends when the
number of participants remaining are equal to the number of licences available. Thus, the subsidy
is equal to the level required to sustain the least efficient rating agency.33
While this type of auction ensures that the most efficient rating agencies win the auction and
also the subsidy is kept at a minimum, it discourages competition and entry. In an ascending
auction, there is a strong presumption that the firm that values winning the most will be the
eventual winner, because even if it is outbid at an early stage, it can eventually top any opposition.
Thus, dominant incumbents with established structures and client base can outbid potential
entrants at any stage. This can create a situation where potential entrants are discouraged to
even participate in the bidding process even in the presence of modest bidding costs. This results
in insufficient competition during the auction and can result in high levels of subsidy due to
cartelisation of incumbents. Thus, in the presence of strong incumbents, this kind of auction
often leads to insufficient competition.
Sealed Bid Auction
In the sealed bid auction or more formally the first price sealed bid auction, all bidders simul-
taneously submit sealed bids so that no bidder knows the bid of any other participant. Bidders
make a single best and final offer. The highest bidder, in this case the rating agency requiring
the lowest subsidy, wins and the subsidy equals its own bid.
From the perspective of encouraging more entry, the merit of a sealed-bid auction is that
the outcome is much less certain than in an ascending auction. An advantaged incumbent will
probably win a sealed-bid auction, but it must make its single final offer in the face of uncertainty
about its rivals bids, and because it wants to get a bargain, its sealed-bid will not be the lowest
33with more efficient rating agencies making a profit
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subsidy it could be pushed to in an ascending auction. So weaker bidders have at least some
chance of victory, even when they would surely lose an ascending auction
Because sealed-bid auctions are more attractive to entrants, they may also discourage consortia
from forming. If the strong rating agencies form a consortium, they may simply attract others
into the bidding in the hope of beating the consortium. So incumbent rating agencies are more
likely to bid independently in a sealed-bid auction, making this auction much more competitive.
Thus the greatest advantage of this type of auction is that it gives weak bidders a chance (a
hope and dream in the words of one frustrated potential entrant) which can attract more bidders
and results in more competition in the bidding process. However, this very fact is also its greatest
shortcoming - because it allows bidders with lower valuations (higher costs in this context) tosometimes beat opponents with higher values (and so encourages entry) it is more likely to lead
to inefficient34 outcomes.
Furthermore, sealed bids do not allow bidders to gather information on the business plans
of their rivals by observing who is staying in and who is getting out as the price rises. They
therefore make it impossible for bidders to refine their valuations of the licences on the basis
of this information. Thus, this type of auction is only recommended when the most important
objective is to encourage potential bidders to entry.35
Hybrid Anglo-Dutch Design
The Anglo-Dutch design tries to marry the benefits of both type of auctions. In an Anglo-
Dutch auction for one object, the price rises until all but two bidders quit and the last two bidders
then make a sealed bids. With 5 licences to sell, the subsidy would fall until only 6 competitors
remained. The surviving bidders would then be committed to bid at or below this level of subsidy
in a sealed-bid auction in which the four lowest bidders are awarded a licence. There are two
versions of the Anglo-Dutch design; one in which each winner is committed to receiving its own
bid, and one in which each winner is committed to paying the fifth-highest winning bid. While the
former is more likely to encourage competition, the latter is more efficient in term of extracting
private information of bidder and incentivising rating agencies to reveal their costs truthfully.
The sealed-bid stage of the Anglo-Dutch design encourages competition by giving a chance
to weaker players. Just as in the standard sealed-bit auction, weaker bidders have a chance of
winning the auction and unlike the ascending price auction be outbid by the dominant incumbents.
This encourages entry into the auction. However, as noted above, this also leads to inefficiencies.
The Anglo-Dutch design tries to overcome this by having an ascending auction as the fist stage.
34rating agency with higher costs winning the auction process35As in the successful Danish 3G Auction of September 2001
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This ensures that the auction does not result in very high levels of subsidies because of under-
bidding by all players. However, by having a sealed-bid stage, it encourages weaker participants
to stay in the auction in the hope of winning in the last stage. Essentially, this design tries to
balance the twin goals of encouraging competition, while at the same time ensuring that there
is an efficient outcome, i.e a high cost rating agency does not win the auction and the subsidy
burden is minimised.
The table below summarises the features of the 3 types of auctions -
Auction Type Entry Efficiency
Simultaneous Ascending Design Lowest Highest
Sealed Bid Auction Highest Lowest
Hybrid Anglo-Dutch Design Moderate Moderate
Table 3: Comparision of different Auction Types
Given that the initial auction is likely to offer more licences than the number of incumbents,
we believe that the Anglo-Dutch design is most appropriate in this setting. It balances the twin
goals of encouraging entry while at the same time ensuring that the most efficient rating agencies
have a greater chance of winning, thus enhancing overall efficiency and keeping the subsidy burden
low. For the later annual auctions, we recommend the sealed bid auction. This is because in the
annual rounds, an incumbent and potential new entrants must compete for a single licence, with 4
other incumbents already part of the industry. In such a situation, more incentives are necessary
for new entrants and the sealed bid auction is most appropriate.
3.3 Industry after the Auction
After the auction, the industry would consist of a given number of rating agencies, competing with
each other for market share. The profits of an individual rating agency would depend critically on
its investor-pay revenues, since the subsidy from the government would be linked to this revenue,
thereby aligning the incentives of the rating agencies with the investors. A critical factor in
determining the attractiveness of this design is the nature of competition in the industry after
the auction and the mechanisms in place to prevent the rating agencies from coming under the
influence of a particular class of investors.
Insufficient competition and cartelisation can lead to moral hazard problems for the industry
leading to high cost and poor quality ratings. However, by its very design, the repeat auction
mechanism ensures competition. The threat of new entry is likely to force the rating agency
with the smallest market share to break the cartel and increase effort in order to gain gain market
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share. This would in turn induce all other rating agencies to exert effort as no rating agency would
want to risk competing in the auction and loose its right to rate. The more likely situation is
intense competition and a race to the bottom. If the rating agencies are homogenous, then this
is the likely outcome with each rating agency undercutting the other resulting in a Bertrand
Equilibrium with subscription fees close to 0. However, ratings are differentiated and we look at
the Industrial Organisation (IO) literature to outline the nature of competition and differentiation
in the ratings industry.
Rating agencies can differentiate each other across two dimensions - the quality of their ratings
and their coverage and specialisation. In the IO literature, the former is classified as Vertical
Differentiationwhile the latter is known as Horizontal Differentiation. Under both these settings,
rating agencies would make positive profits, have different market shares and would cater to
investors with different preferences.36
Vertical Differentiation refers to differentiation on the basis of the quality of ratings. Rating
agencies can choose to provide high quality rating and charge a higher price or they can provide
lower quality ratings for a lower price. Investors choose between the different rating agencies based
on their own preferences i.e quality vs price. The market share of a rating agency would ultimately
depend on the preferences of investors as well as the market segment the rating agency targets.
The IO literature suggest that in general, rating agencies would find it optimal to differentiatethemselves as opposed to competing directly with each other by catering to the same market.37
Horizontal Differentiation refers to specialisation in different products. In this setting, dif-
ferent rating agencies would choose to specialise in different financial instruments and regions.
For example, while one rating agency may specialise in corporate bonds the other may choose to
specialise in structured products. Investors would choose different rating agencies on the basis of
their individual preferences. Thus an investor primarily investing in corporate bonds would go for
the rating agency specialising in corporate bonds while an investor investing in structured prod-
ucts would subscribe to the rating agency specialising in it. Once again, the IO literature suggestrating agencies would choose to differentiate and cater to different segments of the market38
Thus the ratings market can be thought off as a two-dimensional space, with rating agencies
choosing where to position themselves in order to differentiate themselves from their rivals (see
36The current market structure shows some evidence of such differentiation, with the smaller rating agenciesspecialising in particular sectors or regions. See Table 1 for details.
37See Gabszewicz and Thisse (1979, 1980), Gabszewicz and Thisse (1980), Gabszewicz, Shaked, Sutton, andThisse (1981), Bonanno (1986) and Gal-Or (1983)
38See Hotelling (1929) and Salop (1979)
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figure 3). The vertical axis shows quality while the horizontal axis represents specialisation in
different products. Investors choose the rating agency based on their preference for specialisation
and quality. Since ratings are differentiated, the rating agencies have some market power and
make profits in equilibrium.
HorizontalSpecialisation in different products
Vertical
Differencesin
qualityo
fratings
Rating Agency
Figure 3: Market for Ratings - differentiated by quality and specialisation
Note that the distribution of investors in the two-dimensional space need not be uniform.
For example, the proportion of investors demanding very high quality, more expensive ratings
might be much higher than those demanding lower quality, cheaper ratings. The rating agency
targeting the high quality segment of the market will in general have a higher market share.
However, while such a position would be sought after by all rating agencies, once a particular
rating agency positions itself in this position, the other rating agencies would find it optimal to
cater to a different segment of the market. This is because rating agencies would prefer to relax
price competition through product differentiation.39
If it so happens that most of the clients of one particular rating agency belong to a particular
class (say pension funds), then some other rating agency would position itself to target a different
segment of the market. In so doing, they would continue to serve their may economic purpose
39see Shaked and Sutton (1982)
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- to facilitate collective research instead of each investor being forced to conduct research on a
individual basis.
The often sighed danger of investor-pay rating agencies coming under undue influence of
a particular class of investors can be minimises further by requiring rating agencies to make
public the distribution of their investor-pay revenues across the population of investors. Since
rating agencies would already be providing information on their total investor-pay revenues to
the regulators in order to get the subsidy, this should not impose undue burden on the rating
agencies. Such disclosers would make any possible ratings bias clear to the investors. In case the
market is unable to correct the potential biases, such data would also allow regulators to identify
any concentrations or deficits in the market and take corrective measures.
4 Conclusion
Since the credit-crisis, widespread concern has arisen about the functioning and business model
of rating agencies, both at an academic level as well as in policy circles. There exists general
consensus on the need to strengthen the regulation of rating agencies. However, the proposals
currently being discussed are insufficient to resolve the conflict of interest inherent in the issuer-pay
business model of rating agencies. As Branson Davies puts it,40
The rating agencies are so compromised that no amount of regulation can, in my view, make
up for the the fundamental flaws in their incentive structures which is simply a reflection of a
flawed business model.
We look at the proposals currently being discussed and reach a similar conclusion. As is clear
from Table 2, the proposed reforms, by themselves, will have an insufficient impact if the current
issuer-pay model is maintained.
However, drawing on various strands of the academic literature, we propose an alternative
model for the industry which:
Aligns the incentives of the rating agencies
Puts a stop to rate-shopping
Leads to unbiased ratings
Makes the ratings industry commercially viable
40see Davies (2008)
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Results in a market driven, competitive ratings industry
We propose a return to an investor-pay model supplemented by a subsidy from the government.
In order to keep the industry market-oriented and minimise the regulatory burden, we propose
an auction mechanism to provide the right to rate to the most efficient rating agencies. We
further propose repeat annual actions in order to provide a market-based stick to discipline the
rating agencies and ensure dynamism and competition in the industry. Furthermore, our model
addresses two key criticisms of the investor-pay solution to the ratings conundrum. It creates a
supplementary source of revenue for the rating agencies, mitigating the free riding problem. At
the same time, our model ensures that rating agencies are not unduly influenced by a particular
class of investors with their own agendas by forcing rating agencies to compete for investor-payrevenues by differentiating themselves and catering to all classes of investors.
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