Updates – Contrasting News for Rating Agencies: Morningstar Settles with the SEC Whilst Fitch Enters China

Today’s short post provides two updates from the credit rating industry, with each providing particularly contrasting fortunes for the agencies involved.

Morningstar Settles with the SEC

The first story today involves Morningstar, an agency that has been trying to really carve a position for itself in the oligopolistic rating market. Morningstar had reason to be forward-looking this year with its purchase of Sustainalytics being completed in April. The development of the ESG-mainstreaming project means this purchase puts Morningstar in a string position. However, yesterday Morningstar settled with the SEC with regards to charges that it had violated regulations relating to the elimination of internal conflicts of interest. Specifically, the rule that credit rating analysts should not be involved with the sales and marketing efforts of the agency had been violated. The cost of this settlement has been reported to be $3.5 million, but the details provide flagrant breaches of the rules, which in truth are particularly clear. Morningstar was charged with a number of breaches, with one being that an analyst wrote a commentary specifically for an issuer, and sent that commentary directly to the potential client in order to obtain its business, which Morningstar duly did. Another example includes maintaining ABS ratings on clients who analysts were directly dealing with. Morningstar was also found to have breached rules relating to the maintenance of such rules and the internal enforcement of them. The charges related to between 2015 and 2016. Reuters also reports how this action by the SEC, specifically by the Enforcement Division’s Complex Financial Instruments Unit, represents one of only a few actions that the Unit can claim, mostly because of them being under-resourced.

The action reveals a number of elements. The first is that this is not a hugely impactful penalty, and if this constitutes a victory for the Unit, then the observation by Reuters that the Unit is under-funded is likely an astute one. Second, it reveals that no matter the regulations in place, there will be instances of transgression within the industry that is naturally beset with conflicts of interest. Finally, and something which is particularly interesting, it is not just the ‘Big Three’ that are transgressive in this field, which leads to the development of the understanding that it is actually the modern rating model, based on the issuer-pays system, that is the source of the transgressive behaviour – perhaps the necessary closeness between the agencies and the issuers is a fundamental temptation that will not be removed.

Fitch Joins the Chinese Party

Here in Financial Regulation Matters we have looked at the Big Three’s entrance into the lucrative Chinese domestic marketplace for ratings. The development started with S&P, who became the first non-Chinese agency to be allowed into the Chinese marketplace as a stand-alone entity. We discussed how this is linked to the country’s ‘Belt-and-Road’ infrastructure project, and it came as no surprise when, as part of the trade negotiations between the US and China, Moody’s was allowed access to the marketplace too. In a similarly unsurprisingly development, Fitch won approval on Thursday to also enter the Chinese marketplace. The important gatekeepers to the Chinese bond market – the People’s Bank of China (PBOC) and the National Association of Financial Market Institutional Investors (NAFMII) – both approved Fitch Bohua’s registration, the newly-created and wholly-owned Fitch subsidiary. In confirming the similarity to Moody’s the PBOC confirmed that Fitch’s entry was a ‘concrete implementation’ of the Trade Deal that allowed Moody’s entrance to the marketplace. Interestingly, the President of Fitch, Ian Linnell, noted how the ratings were likely to be lower than their Chinese counterparts, which could lead to a ‘tough sell’. If our understanding from previous posts is correct, then this should not be a problem. The whole point of allowing the Big Three into the Chinese marketplace is to bring an international seal of approval to Chinese bonds, which it will need to develop its marketplace and its financial production before the rest of the massive generational-defining infrastructure project really takes shape – it will likely not be as tough a sell as Linnell thinks. It will be interesting to see if China stops at the Big Three, or allows more American-based rating agencies into its market. I suspect not, because the purpose is to bring the ‘signalling’ capacity of the internationally-recognised credit rating agencies into the Chinese market for a specific reason – more entrants would likely only muddy the water and, as China is in control of who conducts business within its borders, it can do as it pleases. Perhaps this is microcosm of the larger identification that one of the most important purposes of a credit rating agency is not the information that it provides, in terms of purely knowledgeable value, but mostly its ability to ‘signal’ to a prospective party, whether that may be investors, regulatory-constrained investors, regulators, or even other states.

Keywords – Credit rating agencies, China, Morningstar, SEC, @finregmatters