Concept of Competition with Respect to Credit Rating

Competition is incentive-driven. Ideally its presence creates incentives for market participants to lower prices, to innovate, or to provide services of high quality. Competitive markets are generally deemed to yield economic benefits such as economic welfare, economic freedom or economic

525 KNIEPS, Sector-Specific Market Power Regulation versus General Competition Law, at 49.

526 Id.

527 Id.

528 DABBAH, International and Comparative Competition Law, at 339.

529 Id.

530 Credit Rating Agencies and the Financial Crisis: Hearing Before the House Committee on Oversight and Government Reform, at 2 (quoting RAYMOND W.MCDANIEL, Chairman and Chief Executive Officer, Moody’s).

ciency.⁵³¹ Overall, competition is associated with the proper functioning of private market forces. Competition protects the freedom of individuals to compete.⁵³² In the absence of competition, CRAs would have no incentive to provide accurate credit ratings.

There are three levels relevant to competition in the credit rating industry.

First, competition in the market for information takes CRAs into account in contradistinction to other gatekeepers. Second, competition in the market for credit ratings takes into account certified CRAs as compared with non-certified CRAs, and the leading CRAs as compared with smaller CRAs.

Third, competition in the market for certified credit ratings takes into ac-count the ac-counterproductive effects of competition among certified CRAs;

competing for increasing market share and revenue may lead to a “race to the bottom” in the presence of rating-based regulations.

Broadly speaking, the credit rating industry is highly concentrated. In gen-eral, oligopolistic structures give incumbents the power to charge monopoly prices and get higher profits.⁵³³ Some economists contend that there is enough competition in the credit rating industry because CRAs do not charge monopoly prices despite the presence of the Moody's, Standard &

Poor's and Fitch oligopoly. Competition was traditionally understood in the narrow meaning of price competition. However, in the modern world, com-petition among CRAs does not only relate to price fixing. Over the last few decades the scope of competition has expanded beyond its initial meaning for it is crucial that CRAs compete on credit rating quality. Therefore, it is important to define competition in terms of not only price but also quality competition.

In the credit rating industry the negative impacts of the oligopoly are de-rived from rating inaccuracies in the sense that leading CRAs have no in-centive to predict financial debacles. Competition pressures are counterpro-ductive if CRAs engage in a “race to the bottom”. Further, conflicts of interest impair the independence of the leading CRAs. The lack of competi-tive incencompeti-tives is especially striking in the issuer-pays business model.

“Rating shopping” jeopardizes the issuance of independent credit ratings.

To make matters worse, the credit ratings of leading CRAs have such a sub-stantial effect on the financial markets that they cannot afford to downgrade on a timely basis. This trend is referred to as the systemic relevance of the

531 MONTI,EC Competition Law, at 23-25, 44-45.

532 ZÄCH &KÜNZLER, Freedom to Compete or Consumer Welfare: the Goal of Competition Law According to Constitutional Law, at 71.

533 See further WHITE, The Growing Influence of Economics and Economists on Antitrust: An Extended Discussion, at 14.

leading CRAs.⁵³⁴ CRAs cannot rate independently of the repercussions of their rating downgrades on the financial system.

In addition, a competitive credit rating market requires as few barriers to entry as possible, as well as no “barriers to exit” in the sense that CRAs not providing valuable information should not survive.⁵³⁵

Competition also means that market participants purchase credit ratings because of their additional value, i.e., if the expected benefit of the credit rating minus the actual cost of the credit rating is positive as well as greater than the expected benefit of an independent investigation minus the actual cost of such an investigation.⁵³⁶ Nevertheless, given the nature of informa-tion as a public good it is challenging to extract investors' fees,⁵³⁷ i.e. to get any individual investor to pay for credit ratings.⁵³⁸

Moreover, a competitive credit rating market signifies that there are diver-gent opinions, and that CRAs do not act in a homogenous way. Financial information should be available to market participants on a competitive ba-sis.

Last but not least, reputational constraints are at the core of a competitive credit rating market. The “reputational capital” view of credit ratings is in-deed consistent with the need for competition in the credit rating indus-try.⁵³⁹ Competition means that CRAs’ reputational capital is at stake in the sense that CRAs would lose more from giving inaccurate credit ratings than they would gain in receiving higher fees.⁵⁴⁰ The reputational motivation should be sufficient to create incentives for CRAs to provide accurate credit ratings.⁵⁴¹ The dominant view of credit rating quality is that a well-func-tioning reputation mechanism will give CRAs optimum incentives for pro-ducing high-quality credit ratings.⁵⁴² In other words, if competition

534 See infra Part 4.

535 PARTNOY, The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies, at 639.

536 Id. at 629.

537 ROUSSEAU, Regulating Credit Rating Agencies after the Financial Crisis: The Long and Wind-ing Road Toward Accountability, at 45 (discussWind-ing the difficulties of limitWind-ing the accessibility of information by excluding investors who have not paid for it).

538 ALEXANDER ET AL., Financial Supervision and Crisis Management in the EU, at 52.

539 PARTNOY, The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies, at 627.

540 Id. at 633.

541 SCHWARCZ, Private Ordering of Public Markets: The Rating Agency Paradox, at 26 (suggesting that the profitability of CRAs is directly tied to reputation).

542 HUNT, Credit Rating Agencies and the “Worldwide Credit Crisis”: The Limits of Reputation, the Insufficiency of Reform, and a Proposal for Improvement, at 112-114, 127-128 (adding, however, that the author does not agree with this dominant view, especially not in relation to structured finance ratings).

tives work adequately in the credit rating industry, CRAs have an over-riding incentive to maintain a reputation for high-quality, accurate credit ratings.⁵⁴³ Therefore, a competitive credit rating market is one which is based on reputation-driven business.⁵⁴⁴

2. Distortions of Competition among Leading Credit Rating