Failed Regulation in the Credit Rating Industry?

This post reviews a recent article in the Wall Street Journal, written by Cezary Podkul and Gunjan Banerji, entitled Inflated Bond Ratings Helped Spur the Financial Crisis. They’re Back. Regular readers will know that the credit rating agencies and their performances over the past two decades have been reviewed extensively and critically here in Financial Regulation Matters on account of the author’s specialism. However, whilst there has been repeated criticism of the agencies themselves, the regulators and their post-Crisis attempts to constrain the industry deserve more attention. The WSJ article suggests that post-Crisis regulatory endeavours have failed and this falls in line with a thesis of this author who has suggested that regulators are regulating imagined, or idealised entities rather than the agencies and the industry as it actually exists. Therefore, we will review the article and ask what its findings mean for post-Crisis regulation in the credit rating arena.

The fascinating article begins by declaring that ‘inflated bond ratings were once cause of the financial crisis. A decade later, there is evidence they persist’. It is claimed that all of the top 6 firms have, since 2012, adjusted their rating methodologies which then went on to result in an increase in their market share. This has been centred upon the structured finance market according to the article, with the authors researching more than 30,000 ratings within a $3 trillion database from the established Big Three (S&P, Moody’s, and Fitch) and the three agencies that have emerged/been encouraged to challenge them since the crisis (DBRS, Kroll Bond Rating Agency, and Morningstar) – we reviewed the acquisition of DBRS by Morningstar recently here. The results of this research suggest, as the article states, that ‘a key regulatory remedy to improve rating quality – promoting competition – has backfired’. This is because the ‘Small Three’, as I will call them here, tended to rate bonds and structured finance products even higher than the Big Three did – the article suggests that on occasion the divergence between the two sets of ratings would be as wide as one being deemed ‘junk’ and the other being deemed AAA, which is a remarkable deviation on the same bond/product. This issue of rating inflation has been found by a number of researchers to exist, almost fundamentally, within the credit rating industry and this WSJ article suggests even further that it is perhaps an inherent characteristic of a credit rating agency (irrespective of whether the agency is an oligopolistic member or not). The influential Professor Bo Becker studied S&P in 2011 when they were shut out of the commercial mortgage-backed securities (CMBS) market and found that, once they could rate in that market again, S&P provided higher ratings than any of its competitors, which lead Becker to argue that this was done in the name of market share. Studies on this topic stretch back to the implementation of the ‘issuer-pays’ model with research from Jiang et al confirming that, when Moody’s incorporated the model and S&P did not, Moody’s ratings were higher – when S&P incorporated the model themselves 3/4 years later, parity was resumed at the higher level between the two rating giants.

The article goes on to cite senior credit analysts from Fitch who suggest that ‘I suppose that’s the flip side, isn’t it, of having more competition among rating agencies’ – the analyst is speaking about the article’s findings that DBRS rated a certain hotel deal as up to two rungs higher than Morningstar because it had just loosened its rating criteria (its then-competitor) and, as a result, its market share jumped by 26%. There is a further issue cited whereby a number of investors urged S&P to not loosen their rating criteria through a fear that changes would lead to a ‘weakening of credit protection for investors at a time where we need it most’ – S&P apparently rejected this call. This led former S&P employee David Jacob to argue that any loss in market share was attributed to harsher rating methodologies and those methodologies were, and continue to be altered accordingly. What is happening now, according to the article, is that the Small Three are attempting to make up for the massive chasm in market share between them and the Big Three by inflating their ratings excessively – DBRS is cited as rating CMBS bonds 39% (S&P), 21% (Moody’s), and 30% (Fitch) higher than its larger competitors (Morningstar and Kroll are apparently no better).

However, the Small Three have responded. Morningstar argued that there is bias in the data analysed by the WSJ because when the Small Three provide more conservative feedback to the issuers, they are often not selected as a result – Morningstar argue that if all of these (then) unpublished ratings were taken into account, then the picture would look very different. Fitch argue that rating diversity is good for investors and that they can take their investment decisions accordingly based upon the variety of ratings available to them. These defences raise a number of important questions which are worth considering.

First, the situation is different for the Small Three, and this needs to be remembered. There is a tendency in the literature (and this article in particular) to consider that all rating agencies are equal – they are not. The pressures on the Small Three are much more acute, and the relationship they have between themselves and the issuers are very different. The issuers have much more leverage, and also it is the case that just through sheer rating volume, unpublished ratings will skew the data set for any such analysis. We can see that the pressures are different with the Small Three as they have had to devour each other, in some sense, to stay alive. The DBRS deal is necessary at the lower end of the market, whilst the Big Three enjoy unrivalled oligopolistic status.

The second question this article raises is to do with regulatory efficiency. The article states that the regulatory action taken in the aftermath of the Crisis has ‘backfired’, but I would argue that the correct term is that is has failed. Any onlooker would have been able to see that the rating industry is not primed for increased competition by its very nature – the rating agencies in the oligopoly certainly do not want it, the issuers do not want it for the most part, and it will (and has) led to increased confusion and complexity for investors. I wrote about the EU’s attempts to do this in 2017 here and we spoke recently of how the EU is starting to admit that this policy is not working. The reality is as I suggested in my book Regulation and the Credit Rating Agencies – there is a massive divergence between the actual and the desired. Regulators and legislators wanted to be seen to be acting in the aftermath of the Crisis, irrespective of the validity of their actions. I argued after the $864 million fine given to Moody’s for its Crisis-era conduct that, for the regulators/legislators, their work was done. However, this is simply not the case and the market is now being burdened by those regulatory actions. The WSJ article cites Becker who states that reliance upon the agencies has gone from ‘high to higher’, despite the aims of the Dodd-Frank and three EU regulations that aimed to destroy that reliance by removal of references within regulation/legislation – Becker found that 94% of rules governing investments ‘made direct or indirect references to ratings in 2017, versus 90% in 2010’. Simply put, this is yet another example of reactive regulating/legislating.

So, what is the solution? That is the ‘million dollar question’ although, in reality, it is worth much more than that. One element that needs to be considered more is the role of investors. Regulators have failed in their quest to positively affect the industry. If we look at the agencies’ collective commitment to ESG principles recently – although we must be particularly cautious when attributing praise in this area just yet – it is clear to see that investor pressure is particularly potent. I discussed this in my book The Role of Credit Rating Agencies in Responsible Finance and it is unquestionable that action, linked to the agencies’ quest for profits, is the most affectual approach that is currently available. If there is a potential to make a lot of money, or a potential that investors will reduce their need for the ratings, then rating agency action will follow immediately afterwards. At the moment the lure of a new marketplace (sustainable finance) is partly determining agency performance and behaviour. The next stage of academic and professional insight must be how professional investors utilise market data for their investment needs. If it is found that, actually, credit ratings are useful to the process (although many esteemed scholars, such as Professor Frank Partnoy, have argued that they are not useful in this sense), then examining ways in which shareholders can institute pressure will be useful to the development to the marketplace. As for regulators, it is vital that they regroup and consider the benefit of reactive regulation. However, the more one thinks of it, it is perhaps legislators who need to develop the most. The thought of, say, the US legislature enacting impactful and potentially constraining reform within a bull market is seemingly unthinkable, and perhaps therein lies the issue – cyclicity in the marketplace tends to have only one consequence… more cyclicity.

Keywords – credit rating agencies, WSJ, rating inflation, @finregmatters