Credit Rating Agencies - Essay Example

Introduction Credit rating agencies have mainly developed in the United s and spread universally. During the greatest depression, one-third of corporate bonds were defaulted, but it was recognized that bonds with high credit rate from those rating agencies had low possibility of default. With this as a momentum, credit rates given by credit rating agencies started to be acknowledged as valuable information by investors. ’s and S&P became two giant agencies in the industry and later Fitch joined and composed big three credit rating agencies. They have played a role of private sector regulator in the global capital market and had 90 percent market share. They have helped financial market fairly well giving out expert opinions to public investors. However, duDuring the financial crisis, three big credit rating agencies, S&P, Moody’s, and Fitch were condemned for precipitating the crisis giving high credit rate to CDOs, which were defaulted. Since then, ratings of the agencies became controversial and financial regulators have sought to ways to impose more regulations on those ratings. Few agencies dominating the rating industry, they are holding too much power in rating market. This settlement allowed only few rates in financial market. If situation keep remain in the rating industry, more financial crisis will happen in near future. Thus, to avoid another critical situation, it is necessary to regulate credit rating agencies more strictly, but also necessary to broaden the market allowing more participants. In the beginning of the industry, credit agencies’ rates had positive impact on financial markets. At that time, many people who didn’t have financial knowledge had difficulties in choosing where to invest their money. The companies who solved the problems were credit rating agencies. They were consisted of financial experts and analyzed companies and gave easily understandable “ABC” rates. According to them, high credit rating which was closer to “As” rates indicates that the borrower has a low probability of defaulting on debt, and conversely low credit rating indicates that the borrower has a high probability of defaulting. Investors could get helped in deciding the companies to invest relying on those rates. Essentially, what they have done is facilitating investments by giving easily understandable reliable sources to judge risk of investments. These rates have had a huge impact on financial markets. Since credit agencies have developed and settled in the financial industry, a lot of investors began to consider those rates as an important standard to make investments. Since a lot of investor wanted higher rates to avoid risk of default, companies or issuers of bonds desired to get higher rates since, by having high rates, companies and issuers could easily gather a lot of funds. The problem here is that credit agencies get paid from those companies or issuers. Companies and issuers were willing to pay tons of money to the agencies and the credit agencies naturally give a bit of higher favorable rate to them. One important example that this system became a problem is CDOs which is made by investment banks. These CDOs contributed a huge part of the recent financial crisis. At that time, these CDOs bear high risk of default, but got “AAA” rate which is the highest credit rates from three giant credit rating agencies. Investors such as pension fund which was only allowed to invest in certain high rate invested in those CDOs and a lot of other investors also invested in those CDOs believing it has low probability of defaulting. It brought a lot of funds in financial markets and seemed having good days. However, after bubble in the financial market breaks, those CDOs began to be downgraded under junk grade and investors got panicked by the situation. To put it simple, credit agencies gave much higher rates to CDOs which was actually bearing a lot of probability of defaulting getting paid an astronomical amount of money. Subsequently, credit rating agencies had responsibility in triggering financial crisis. However, what those credit agencies did was not taking responsibility, but arguing their rates were just opinions. Since how they have evaluated companies or issuers of bonds were inside information, no one could find out how defaulted CDOs got “AAA” rates. Also, there were no laws to make credit agencies take responsibilities of their irresponsible “opinions”. Through this financial crisis and ethical problem of credit rating agencies, people found need to regulate credit agencies biased credit ratings. Since then, European and US financial regulators have tried to find ways to regulate those agencies. So to regulate markets, policy makers have focused on shortcomings arising from the following concern; conflicts of interest and lack of competitions. One of the problems in the credit rating industry are that those agencies get paid directly paid from the companies. According to Economist, “the fact that issuers still pay for ratings, rather than investors, has also helped maintain demand. Companies issuing bonds benefit from getting them rated by the agencies. The return in lower borrowing costs can be up to ten times as much as the fees paid for the rating. Regulations that still make it virtually impossible to sell unrated bonds in America are also a boon.” As mentioned above, the system that issuers of bonds or companies who want to get rated pays direct compensation to credit agencies is the root of this conflict of interest. If this system of payment exists in the market, this conflict of interest cannot be fixed. It is always better ideas for companies pay money to the agencies instead of paying more interest and the agencies has no reason to deny tons of money they are receiving. To solve the problem of conflict of interest, this system should be changed. An idea of regulating this payment relationship is allowing only “flat fee”. If governments allow credit agencies to accept only “flat fee” for their services, credit agencies would not rely on revenues from direct payment by subjects they are rating and they might be more objective in their rating. Of course, all the rating services cannot be priced same. Regulators can give detailed guideline for credit agencies depending on the scale or importance of rating and limit the maximum amount of compensations credit agencies can receive. One downside of this regulation may make credit rating industry less profitable, and many new entrants who felt interest in the industry can lose the interest after the regulation. Thus, the market can be smaller and also the information investors can get help might be smaller. However, if governments support them and officially subsidizing those credit agencies, more new agencies will participate in market and more unbiased rating will be available. Then this structure of the industry may prevent monopolizing of few giant agencies. However, the flat fee is not the only solution for conflict of interest. Even though credit agencies do not pursue profit for their own good, the problem that credit agencies can issue irresponsible opinions and try to avoid responsibility for the opinions is still unsolved. To solve this problem, additional regulation for giving the agencies penalties for issuing wrong opinions should be made. An idea of this solution is making governmental institute evaluating those credit rating agencies. The way this governmental institute function is that the institute evaluates credibility of the agencies based on accuracy of their rates and if some agencies issued too inaccurate rates, the institute downgrades the credibility of the agencies. Evaluating these agencies make investors able to look up which agencies are reliable and can obtain credible information from those agencies. The other problem of this credit rating industry is lack of competitions. According to Economist, “All told, the ratings agencies’ business “has not been threatened much by extra regulation or competition”, says Douglas Arthur at Evercore Partners, an investment bank. Although outfits like Scope have tried to challenge the big three’s dominance, the trio still control around 95% of the global ratings market: the same as before the crisis. With bond markets booming again, ratings agencies are back to their profitable and controversial old selves.” As explained above, the problem of credit rating industry is partly derived from the market condition that only three big companies, S&P, Moody’s, and Fitch, is dominating. Because of this market condition, only few options are allowed to companies who want to get rated, so the three giant agencies are holding too much power in the industry. According to Marc Joffe, “To become a new NRSRO, a firm must submit 10 letters from Qualified Institutional Buyers stating that they have happily used the firms ratings for at least three years. This requirement is somewhat circular, because it is hard for a new rater to gain attention from institutional buyers without being an NRSRO. Once a rating agency joins the NRSRO club it faces enormous compliance costs in terms of both employees training and reporting. Upstart Egan Jones recently found that the penalties for making errors on mandatory Securities and Exchange Commission (SEC) filings can be quite severe. The compliance burden actually favors the big three because they generate enough revenue to fully staff compliance units. New entrants often lack this luxury.” As Marc Joffe insisted, current system of credit rating industry is favorable for three big companies and makes new entrants difficult to enter. Since the system itself in credit rating industry is dominated by three big companies, other entrants who want to join cannot actually capture the market shares and compete with those big agencies. Conclusion and recommendations During financial crisis, three big credit rating agencies, S&P, Moody’s, and Fitch were blamed for giving biased credit ratings. In the beginning of the credit rating industry, they were helpful to investors and played an important role in financial market. However, as system of the industry becomes too favorable for credit agencies and only three big agencies monopolize the market, ethical issues began to arise. These ethical problems eventually contributed a considerable part of financial crisis. As proved through recent financial crisis, if current system of rating industry remains same in the future, there might be more ethical problems giving biased rating and financial market will be impacted by those rates. Thus, to avoid another chaos in financial market and make the market stable, credit rating agencies should be regulated more strictly to prevent conflict of interest, but also should allow more new credit agencies to have more objective opinions. The suggestions to achieve these goals, government should regulate the current payment system in the credit rating industry, make an institute that evaluates credit agencies’ credibility and support growth of new entrants. These solutions would help credit rating industry be more transparent and investors have more objective various opinions from experts. Then how can this problem of lack of competition be solved effectively? To solve this problem, it would be a better idea that financial regulators allow more credit agencies to participate in market and support their growth. By doing this, more new entrants will be settled in the industry and various opinions will be given. Then the credit rating industry will be controlled by a lot more agencies and this will reduce the influence of a few giant companies in financial market. One specific idea of this is that government directly order random ratings to those new entrants and pay the service fee for certain period of time such as one year. This support for new entrants will make more credit agencies participate in the rating industry. However, the downside of this support is that too many agencies will participate in the industry aiming the support from government. The solution for this situation is regulation based on evaluation by the institute mentioned above. If a credit agency is downgraded to certain level by the institute, because issued too inaccurate rates during supported period, government can simply stop support for the credit agency and ask the agency to pay back certain level of money such as 50 percent of they received. By establishing this kind of support system, government can prohibit new credit agencies from entering the industry irresponsibly and also achieve the goal of having more credit agencies in the industry. Bibliography "Credit Where Credits Due; Ratings Agencies." The Economist, April 19, 2014. Joffe, Marc. "Moodys, S&P and Other Credit Rating Agencies Deserve a failing Grade." The Guardian, February 25, 2013. Accessed January 27, 2015. Read More