Regulation and the Credit Rating Agencies

Restraining Ancillary Services

Daniel Cash

• Publisher: Routledge
• Year: 2018
• eBook ISBN: 9781351107891
• Edition: 1
• Topic: Law
• Subtopic: Business Law
• Index: Law

This book examines the transgressions of the credit rating agencies before, during and after the recent financial crisis. It proposes that by restricting the agencies' ability to offer ancillary services there stands the opportunity to limit, in an achievable and practical manner, the potentially negative effect that the Big Three rating agencies – Standard & Poor's, Moody's and Fitch – may have upon the financial sector and society moreover. The book contains an extensive and in-depth discussion about how the agencies ascended to their current position, why they were able to do so and ultimately their behaviour once their position was cemented.

This work offers a new framework for the reader to follow, suggesting that investors, issuers and the state have a 'desired' version of the agencies in their thinking and operate upon that basis when, in fact, those imagined agencies do not exist, as demonstrated by the 'actual' conduct of the agencies. The book primarily aims to uncover this divergence and reveal the 'real' credit rating agencies, and then on that basis propose a real and potentially achievable reform to limit the negative effects that result from poor performance in this Industry. It addresses the topics with regard to financial regulation and the financial crisis, and will be of interest to legal scholars interested in the intersection between business and he law as well as researchers, academics, policymakers, industry and professional associations and students in the fields of corporate law, banking and finance law, financial regulation, corporate governance and corporate finance.

1A primer on the credit rating domain

Introduction

In essence, the primary role of the rating agencies is to assist a range of investors in making informed investment decisions.¹ In theory, the expert research and analysis conducted by the agencies protects investors from ‘unknowingly taking credit risk’.² However, the vast losses incurred throughout the financial crisis, particularly those involving investments in highly rated financial products,³ means that to assess the reality of the rating industry’s role is a particularly worthwhile endeavour.

This chapter, therefore, represents a primer on the credit rating industry. The incredible effect that the ratings agencies have⁴ means that if we are to analyse the intricacies of this unique industry effectively, then this elementary assessment will be extremely important. To do this, the chapter will primarily ask three questions: Who are the credit rating agencies? What is it that they do (including their role within the economy)? What is the regulatory framework that governs them?

Throughout the book there will be constant references to ‘the credit rating agencies’ or the ‘ratings industry’, but those blanket terms conceal dynamics within the ratings industry that are very important to understand. For example, an analysis of the global market share and ratings distribution (i.e. produced) within the ratings industry reveals an extraordinary concentration of power among three agencies: Standard & Poor’s, Moody’s and Fitch Ratings. Analysing these industry dynamics will be very important if we are to answer this chapter’s second question, namely ‘What do rating agencies do and what is their role within the economy?’

Although there is a lot of discussion to be had regarding the role of the industry, the validity of their position and many other aspects, what is not debatable is their current significance to the fluidity of the capital markets. With the capital markets being the foundation of the modern economy, the use of credit ratings by large institutional investors, banks and other large financial entities means that understanding the industry’s role will be an important, but complex, affair.

The complexity of the role means that the task of regulating the industry is extraordinarily difficult. The incredible amount of analysis of the failings surrounding the ratings industry and their role in the financial crisis perhaps points to the conclusion that regulators have failed in overcoming such a difficult task. However, in order to assess whether such an understanding is correct, it will be very important to provide a basic understanding of the regulatory framework that governs the industry and its exploits. The regulation of the ratings industry in the United States is primarily a statutory endeavour, with the Judiciary and Department of Justice being mostly concerned with elements of fraudulent or criminal behaviour.⁵ As we shall see, infringements of economically concerned legislation (e.g. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010,⁶ (hereafter the ‘Dodd-Frank Act’)) are punished by fines from the Securities and Exchange Commission (SEC) predominantly, although the SEC does theoretically have other powers at its disposal. In establishing and understanding this regulatory environment within which the ratings industry operates, we will be better able to understand any perceived or potential deficiencies in the regulatory approach to the conduct of the ratings agencies.

The industry: who they are

In terms of the global market for credit ratings there are two important aspects. Firstly, the global ratings industry contains over 100 rating agencies, with the vast majority being concerned with local economies or specialised fields.⁷ Secondly, this vast market is dominated by only three agencies, with Standard & Poor’s, Moody’s and Fitch controlling over 90 per cent of the market.⁸ This dominance has been recognised as being a de facto oligopoly,⁹ although closer analysis of the precise market share and dynamics of the financial markets hints at the existence of ‘a partner monopoly’ between Moody’s and Standard & Poor’s¹⁰ or, to be less cynical, a cross between a duopoly and an oligopoly.¹¹

Moody’s Corporation is the parent company of two legally separate operating divisions: Moody’s Investors Service and Moody’s Analytics.¹² Moody’s Investors Service (MIS) ‘provides credit ratings and research covering debt instruments and securities’, whereas Moody’s Analytics (MA) ‘offers leading-edge software, advisory services and research for credit and economic analysis and financial risk management’.¹³ These services offered by Moody’s Analytics are classified for regulatory purposes as ‘Ancillary Services’ and are defined by Moody’s as ‘products and services that are not Credit Rating Services and which are market forecasts, estimates of economic trends, pricing analysis or other general data analysis, as well as related distribution services’,¹⁴ though it is worth noting in addition to Moody’s’ self-definition that MA is also the division that controls the sales and marketing efforts for the corporation as a whole.¹⁵ Regulation in light of the recent financial crisis has ruled that the activities of the rating and ancillary entities of the ratings agencies that offer such services must be kept separated.¹⁶

Moody’s is a particularly vast financial entity in its own right. Its total revenue for the financial year of 2016 was $3.6 billion, with an operating margin of 17.7 per cent (down from 42 per cent the year earlier because of fines and settlements);¹⁷ commentators have traditionally been keen to note that this margin (before the penalties in 2016/17) is much higher than a host of more recognisable entities such as Google, Microsoft or ExxonMobil.¹⁸ MIS rates approximately 130 sovereign nations, 11,000 corporate issuers, 21,000 public finance issuers and roughly 76,000 structured finance obligations. In order to do this, the firm employs nearly 10,000 people worldwide and has a presence in 33 countries.¹⁹ Organisationally, legendary investor Warren Buffett’s Berkshire Hathaway is the majority shareholder with the influential Vanguard Group also holding significant shares in the company, perhaps signifying the incredible investment opportunity that Moody’s represents.

Standard & Poor’s is equally as impressive, if, indeed, not more so.²⁰ However, while Moody’s is a stand alone public corporation, Standard & Poor’s is not. It represents just part of the activities of the US-based group McGraw-Hill, which also contains other businesses in the field of publishing and education.²¹ Standard & Poor’s, though at one time just a division of the parent company, was transformed in 2009 into a wholly owned subsidiary and contributes over $3 billion to McGraw-Hill’s total revenue, providing for 44 percent of its total.²²

Standard & Poor’s also contains a division that supplies Ancillary Services to the market, via S&P Capital IQ,²³ which in a similar vein to their counterparts at Moody’s Analytics, offers ‘the highest quality financial intelligence covering both public and private capital markets’.²⁴ Standard & Poor’s must also disclose under regulatory rules the pre-emptive actions taken to ensure the separation of rating and commercial entities.²⁵

The third component of the oligopoly that dominates the rating industry is Fitch Ratings. An amalgamation of a number of rating agencies,²⁶ Fitch Ratings, as part of the Fitch Group, is majority owned by the influential Hearst Corporation; Hearst increased its equity share at the expense of the previous majority holder, French conglomerate Fimalac, in 2014.²⁷ Fitch also has its own designated ancillary service provider in Fitch Solutions; like the comparable divisions at Standard & Poor’s and Moody’s, this requires separation from the commercial entities contained within the group as a whole.²⁸ Owing to its status as a subsidiary of both the Hearst Corporation and Fimalac, gaining any sense of the scope of the Fitch Group is particularly difficult, although Fimalac reported that in 2013 the Group generated revenues of $982 million,²⁹ which in itself clearly demonstrates the disparity between Fitch and the two leading agencies in the field.

As the large financial entities that dominate the capital markets are often required by regulation to utilise the ratings of rating agencies, it should come as no surprise that ‘the Big Three’ are all registered to both the SEC and the European Securities and Markets Authority (ESMA). It should come as no surprise because it is perhaps reasonable to assume that the state would want to formally oversee the entities that it is forcing upon large and influential market actors, although as we shall see in A Snapshot of the Regulatory Framework, this formal registration only took place from 2006 onwards. Apart from the Big Three, there are a few other registered agencies that may be worth mentioning, although it must be noted that the reason for their inclusion into this analysis is to fulfil the aims of providing a thorough primer of the industry; their combined market share actually makes them rather insignificant when compared to the a...

Table of contents

• Cover
• Half Title
• Series Information
• Title Page
• Copyright Page
• Dedication
• Contents
• Acknowledgements
• Introduction
• 1 A primer on the credit rating domain
• 2 The divergence between the actual and the desired
• 3 Why the agencies transgress and what allows them to do it
• 4 Tried and failed
• 5 The issue of ancillary service provision
• 6 A reform proposal
• Conclusion
• Index