PART 4: System-Wide Effects of Credit Rating Downgrades
I. Credit Rating Oligopoly
“Three is no crowd.”938
The question arises as to whether CRAs are in fact driven by private market forces. Regulatory concern has been raised about the lack of competition in the credit rating industry. The three leading CRAs – Moody’s, Standard &
Poor’s and Fitch – have repeatedly been accused of abusing their market power. They are allegedly able to mislead investors that rely on their credit ratings. The dominance of the rating market by the three leading CRAs may have detrimental effects on the proper functioning of competitive forces in the credit rating industry.939 One specific issue is related to the potentially devastating effects of credit rating downgrades by the leading CRAs.
In this part, attention is first paid to describing concentration in the credit rating industry. Market shares are almost exclusively divided among the three leading CRAs. Second, competition is reduced by high barriers to en-tering the credit rating industry. The underlying reasons preventing new entrants from gaining market share to the detriment of the three leading CRAs are primarily derived from historical, natural and regulatory barriers to entry.940 Third, as a consequence Moody’s, Standard & Poor’s and Fitch are well-established in the credit rating industry.941 Their strong position in the financial markets results in market power they can use to protect their interests.
1. High Concentration in the Credit Rating Industry
The credit rating industry is without doubt a heavily concentrated industry.
As regards market structure, the credit rating industry is a 5 to 6 billion US dollar market with Moody's, Standard & Poor's and Fitch controlling more
938 THE ECONOMIST, Three is No Crowd, Regulators need a new approach to an entrenched industry, at 15.
939 See supra Part 2, Chapter 5.
940 HILL, Regulating the Rating Agencies, at 84, 91.
941 See, e.g., FROST, Credit Rating Agencies in Capital Markets: A Review of Research Evidence on Selected Criticisms of the Agencies, at 471.
than 90 percent.942 Moody’s and Standard & Poor’s control over 80% of the credit rating market so that some talk about a duopoly of these two CRAs.943 The third leading CRA, Fitch, is also very significant in the sense the three are commonly referred to an oligopoly.944 Overall, there are ap-proximately a hundred and fifty other smaller CRAs, which are regional or sectoral.945 In any case, the three leading CRAs are the only relevant CRAs from the perspective of the international financial architecture. The three leading CRAs issue 98 percent of the total credit ratings and collect ap-proximately 90 percent of the total rating revenue.946
2. Barriers to Entering the Credit Rating Industry
Barriers to entering the credit rating industry can undermine competition.947 From a structural perspective, barriers to entry are the primary cause of the high concentration in the credit rating industry. Moreover, they reinforce the leading CRAs’ market power. The presence of barriers to entry leads – in any case – to less vigorous competition than in a situation with fewer barriers and more players.948 Potential competitors are able to exercise competitive pressure only if they are in a position to enter the credit rating
942 Credit Rating Agencies and the Financial Crisis: Hearing Before the House Committee on Oversight and Government Reform (statement of SEAN J.EGAN, Managing Director, Egan-Jones Ratings), at 42.
943 See EU Commission Staff Working Document, Accompanying the Proposal for a Regulation of the European Parliament and of the Council on Credit Rating Agencies, Impact Assessment, at 9 (stating that Moody’s and Standard & Poor’s have a combined market share in excess of 80 percent, and Fitch has approximately 14 percent). See generally US Credit Rating Agency Reform Act of 2006, Sec. 2(5) (stating that the two largest CRAs – Moody’s and Standard &
Poor’s – serve the vast majority of the market); see, e.g., Assessing the Current Oversight and Operation of Credit Rating Agencies: Hearing Before the Senate Committee on Banking, Hous-ing and Urban Affairs (statement of GLENN L.REYNOLDS, Chief Executive Officer, Credit-Sights), at 8.
944 See WHITE, Financial Regulation and the Current Crisis: A Guide for the Antitrust Community, at 10 (referring to Moody’s and Standard & Poor’s as the two largest CRAs and to Fitch as the third one – a modest sized firm); see also BALZLI &HORNIG, Exacerbating the Crisis, The Power of Rating Agencies (stating that Moody's, Standard & Poor's & Fitch are colloquially known as “The Big Three”).
945 See, e.g., ESTRELLA ET AL., Credit Ratings and Complementary Sources of Credit Quality Information, at 14; see also SHORTER & SEITZINGER, Credit Rating Agencies and Their Regulation, at 1 (stating that there are approximately hundred CRAs); see further EU Commis-sion Staff Working Document, Impact Assessment, Accompanying Document to the Proposal for a Regulation of the European Parliament and of the Council Amending Regulation (EC) N°1060/2009 on Credit Rating Agencies, at 7, 38 (stating that approximately fifty regional CRAs are established in the EU).
946 SHORTER &SEITZINGER, Credit Rating Agencies and Their Regulation, at 3.
947 See supra Part 2, Chapter 4(II)(3)(a) (defining barriers to entering the credit rating industry and explaining that the regulatory barrier to entry should be removed to enhance competition among CRAs).
948 HILL, Regulating the Rating Agencies, at 63.
market. Therefore, a key feature of a competitive market structure consists of keeping barriers to entry as low as possible.
CRAs face historical, natural, institutional and regulatory barriers to en-try.949 The historical barrier to entry results from trust based on the reputa-tional capital that the leading CRAs have built up over many years.950 Issu-ers tend to hire CRAs that are widely recognized among investors; new entrants – i.e. potential competitors – cannot present historic track re-cords.951 The natural barrier to entry is derived from the fact that the rating market may not be able to accommodate many general-purpose CRAs.952 The presence of economies of scale suggests that the credit rating industry may necessarily be dominated by few leading CRAs.953
The regulatory barrier to entry is created by regulators and does not exist
“per se”.954 Rating-based regulations raise a regulatory barrier to entry.955 In particular, the regulatory recognition of CRAs can potentially act as a bar-rier to entry for new market participants, i.e. potential competitors.956 Hence the certification process reduces competition in the credit rating in-dustry by limiting potential entrants.957
949 Id. at 84, 91.
950 FLOOD, Rating, Dating, and the Informal Regulation and the Formal Ordering of Financial Transactions: Securitisations and Credit Rating Agencies, at 160.
951 BLAUROCK, Verantwortlichkeit von Ratingagenturen – Steuerung durch Privat- oder Aufsichts-recht?, at 607.
952 HILL, Regulating the Rating Agencies, at 62 (adding that pre-NRSRO history provides some support for this argument).
953 SCHWARCZ, Private Ordering of Public Markets: The Rating Agency Paradox, at 12. Economies of scale exist if only large scale entries are possible or if potential competitors suffer disadvantages when they try to conduct small scale entries).
954 See, e.g., WHITE, Financial Regulation and the Current Crisis: A Guide for the Antitrust Com-munity, at 30.
955 PINTO, Control and Responsibility of Credit Rating Agencies in the United States, at 9 (stating that the NRSRO status reduces competition in the credit rating industry by limiting new entrants, i.e. potential competitors); CROUHY,JARROW &TURNBULL, The Subprime Credit Crisis of 07, at 9; FSF,Report of the Financial Stability Forum on Enhancing Market and Institutional Resili-ence, at 38; WEBER &DARBELLAY, The regulatory use of credit ratings in bank capital require-ment regulations, at 6.
956 FSF,Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience, at 38; but see IOSCO,Report on the Activities of Credit Rating Agencies, at 9 and IOSCO, Report of the Task Force on the Subprime Crisis, Final Report, at 27 (noting that the nature of the CRA market makes it difficult for new entrants to succeed regardless of any regulatory barriers to entry; moreover, regulatory recognition criteria are based on how extensively credit ratings are used by market participants, i.e. the reputation of CRAs in the market; in addition, market participants prefer to use credit ratings that regulators also use, implying that the cycle of discrimination is perpetual).
957 PINTO, Control and Responsibility of Credit Rating Agencies in the United States, at 9 (referring to the NRSRO status in the US).
The combination of historical with regulatory barriers to entry has resulted in the widespread dominance of the leading CRAs.958 As a consequence, eliminating the regulatory dependence on credit ratings is the best way to foster a competitive environment in the credit rating industry. If rating-based regulations are withdrawn, barriers to entry will probably not be fully eliminated but will at least be reduced significantly.
3. Collective Market Power of the Leading Credit Rating Agencies
High concentration in the credit rating industry and high barriers to entry resulted in the strong market dominance of the three leading CRAs – Moody's, Standard & Poor's and Fitch. Indeed, the Big Three enjoy a cer-tain privilege since market participants have little alternative to their credit ratings. Over the past decades, although rating scandals have repeatedly tarnished their reputation, the Big Three continue to flourish in the financial markets.959 They have long dominated the credit rating market and continue to do so despite their failure to predict the subprime mortgage crisis.960 The strong market power of the three leading CRAs significantly contributes to the lack of competition in the market for information.961 Leading CRAs dominate the credit rating market and – to some extent – even the market for information in a broader sense.
Further, the fact that issuers and investors prefer to choose CRAs that enjoy the most market recognition reinforces the market power of the three lead-ing CRAs. Concern has especially been raised about the issuer-pays busi-ness model. The issuer-pays busibusi-ness model is heavily criticized because it creates conflicts of interest in the rating process.962 In this regard, the is-suer-pays business model jeopardizes the independence of the CRAs.
Moreover, as regards the market power of the Big Three there is another reason to be skeptical of the pays business model. Under the issuer-pays business model issuers prefer to hire CRAs that enjoy the greatest market reliance.963 This means that CRAs that have the greatest market shares will automatically tend to be selected by issuers. Issuers are only willing to pay for credit ratings if the hired CRAs enjoy sufficient market
958 ABDELAL,Capital Rules, The Construction of Global Finance, at 173.
959 See, e.g., GILLEN, In Ratings Agencies, Investors Still Trust.
960 BALZLI &HORNIG, Exacerbating the Crisis, The Power of Rating Agencies.
961 See supra Part 2, Chapter 5.
962 See, e.g., MATHIS,MCANDREWS &ROCHET, Rating the raters: Are reputation concerns powerful enough to discipline rating agencies?, at 669.
963 IOSCO,Report on the Activities of Credit Rating Agencies, at 9; IOSCO, Report of the Task Force on the Subprime Crisis, Final Report, at 27.
recognition. This phenomenon contributes to strengthening the rating oli-gopoly even when the leading CRAs do not allocate more resources to the rating process. The more a specific CRA gains market share and obtains market reliance, the more issuers are interested in getting their debt instru-ments being rated by the targeted CRA. Therefore, leading CRAs tend to attract even more market power and be decreasingly subject to competitive pressures.