Information Intermediaries and Competitive

other market participants such as gatekeepers.⁵⁶⁷ It is important to look at the economic motivation of the different market participants and their in-centives. With respect to CRAs, it is crucial to address the market dis-ruptions that have been observed during the recent rating scandals. Focus is put on removing structural impediments to competition. As mere

564 Assessing the Current Oversight and Operation of Credit Rating Agencies: Hearing Before the Senate Committee on Banking, Housing and Urban Affairs (statement of PAUL SCHOTT STEVENS, President, Investment Company Institute), at 7.

565 See BIRCHLER &BÜTLER, Information Economics, at 31-33.

566 See further THE ECONOMIST, The Other Vampires, Pressure Mounts on an Oligopoly, at 83-84 (“The European Commission is looking at the idea of creating a home-grown rating agency as a counterweight to the American trio”).

567 See WHITE, Financial Regulation and the Current Crisis: A Guide for the Antitrust Community, at 29 (stating that CRAs “have never been the only source of information about bonds”).

tion intermediaries, CRAs should seek to provide additional information and resolve information asymmetries.⁵⁶⁸ The presence of CRAs in financial markets should tend to increase market transparency and decrease the cost of capital.⁵⁶⁹ The advantage of intermediaries in financial markets is that they may be able to capture some of the value that market participants hav-ing information cannot earn due to the reliability problem, i.e. investors would not easily rely on information coming directly from from borrowers and issuers.⁵⁷⁰ Indeed, the cost of capital for borrowers and issuers would be higher if CRAs did not act as information intermediaries by providing investors with independent information.⁵⁷¹

The classical view of the market for financial information implies that there is a supply of and a demand for information.⁵⁷² The market for information is a competitive business if CRAs compete on rating quality to procure fees to provide their services. Credit ratings must be regulated as financial in-formation. As a market for information, the credit rating market can be con-sidered to be competitive if it is characterized by a diversity of opinions. A too concentrated credit rating industry that benefits from excessive market power can lead to a homogenization of opinion whereas financial markets should reflect a diversity of opinions driving market participants to trade according to their own perceptions. Credit ratings cannot be used as the unique source of information.⁵⁷³ In this respect, financial markets exist be-cause market participants interpret uncertainty in a variety of ways. If in-formation is homogenized, a confidence crisis in credit rating accuracy may totally destabilize the market. Therefore, the market for information should be a very competitive market.

568 See SCHWARCZ, Private Ordering of Public Markets: The Rating Agency Paradox, at 12; see also BEAVER,SHAKESPEARE &SOLIMAN, Differential properties in the ratings of certified versus non-certified bond-rating agencies, at 306.

569 LYNCH, Deeply and Persistently Conflicted: Credit Rating Agencies in the Current Regulatory Environment, at 241.

570 See generally ALLEN, The Market for Information and the Origin of Financial Intermediation, at 3 (referring to the principal-agent problem).

571 MOLONEY, EC Securities Regulation, at 687-688.

572 PARTNOY, The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies, at 631.

573 See further WHITE, Financial Regulation and the Current Crisis: A Guide for the Antitrust Community, at 29.

2. Information Asymmetries and the Cost of Financial Information

The presence of asymmetric information means that borrowers or issuers always know more than investors.⁵⁷⁴ As information intermediaries, CRAs are supposed to address information asymmetries. However, concern has been raised that they fail to clear the fog of information asymmetry because they take advantage of their role as financial information gatekeepers. In the absence of competition, leading CRAs take advantage of information asymmetries and have no incentive to provide market participants with val-uable information. The presence of information intermediaries resolve in-formation asymmetries but can also serve as a smokescreen as was the case in the years preceding the subprime mortgage crisis.

CRAs should be disciplined by competitive incentives so that they seek to reduce information asymmetries in the financial markets.⁵⁷⁵ In the presence of a competitive market for information, CRAs that fail to provide investors with additional and valuable information would not survive. Accordingly, information asymmetry can partly explain the reoccurence of systemic cri-ses.⁵⁷⁶ If investors are left with no other means but to rely on CRAs, infor-mation asymmetries will be exacerbated in difficult times. When the sub-prime mortgage market collapsed, investors could not distinguish between good and bad assets.⁵⁷⁷ From the investors’ perspective, all bonds with the same rating looked alike.

The cost of information is another important aspect of a competitive market for financial information. Issuers and investors purchase credit ratings based on the benefits that they expect from the information provided. Gen-erally, the cost of financial information is the expected utility with the in-formation minus the expected utility without.⁵⁷⁸ Issuers and investors esti-mate the difference between the additional value provided by the information and the price paid to obtain that information.

574 It is the case of a principal-agent relationship between issuers and investors whereas issuers – as agents – have more information than borrowers – as principals.

575 See, e.g., HUNT, Credit Rating Agencies and the “Worldwide Credit Crisis”: The Limits of Reputation, the Insufficiency of Reform, and a Proposal for Improvement, at 138, 155 (stating that competitive incentives – in the sense of reputation for quality – exist if market participants can monitor CRA performance ex-post).

576 KUHNER, Financial Rating Agencies: Are They Credible? – Insights into the Reporting Incen-tives of Rating Agencies in Times of Enhanced Systemic Risk, at 5.

577 See AKERLOF, The Market for „Lemons“: Quality Uncertainty and the Market Mechanism, at 490-491.

578 BIRCHLER &BÜTLER,Information Economics, at 32, 42.

Under the issuer-pays business model, the value of credit ratings is linked to the expected benefits that issuers – as buyers of credit ratings – expect from the ratings. If issuers get regulatory advantages by purchasing credit ratings, the price for credit ratings will be distorted as a consequence there-of. In modern financial markets, there is serious reason to doubt that the substantial fees paid by issuers are consistent with a competitive market for financial information.⁵⁷⁹

Under the investor-pays business model, competitive markets make sure that investors pay for the value of the information. They price information.

CRAs should be paid only if they provide additional information. Never-theless, credit ratings are often blamed for being lagging indicators of the creditworthiness of borrowers or debt instruments. In this sense, they do not provide more information than already publicly available. Investors have no incentive to pay for credit ratings if they do not get valuable information. A competitive market for financial information would make sure that CRAs bear negative consequences when they fail to anticipate financial shocks.

Therefore, market forces should discipline the leading CRAs so that their market value reflects the informational value of their credit ratings.

§ 6. Preliminary Conclusion

The competitive environment in the credit rating industry depends to a sub-stantial extent on the regulatory structure. CRA reforms have played an im-portant role in the US and in the EU in the aftermath of the 2007-2009 fi-nancial crisis.

Three types of regulatory intervention effect the interplay of market forces among CRAs. First, the withdrawal of regulatory references to credit rat-ings undoubtedly enhances the level of competition in the credit rating in-dustry. CRAs that are not recognized for regulatory purposes may be able to compete with the leading CRAs more easily. Looking for alternatives to credit ratings may also open the door to new entrants in the market for fi-nancial information.

Second, enhanced CRA oversight may have positive but also detrimental impacts on competition. Although public oversight is necessary to disci-pline CRAs, the establishment of a stringent regulatory framework may also raise additional barriers to entering the credit rating market.

579 PARTNOY, The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies, at 655.

ingly, designing CRA oversight should always be assessed as to its effect on competitive incentives.

Third, special treatment for CRAs clearly reduces competition in the credit rating industry. In the US, CRAs used to benefit from a privileged position given their immunity from lawsuits and their exemption from SEC Regula-tion FD. The Dodd-Frank Act of 2010 amended the legal and regulatory framework so that CRAs will be treated the same as other financial gate-keepers such as securities analysts and auditors. The EU is also considering harmonizing CRA liability regimes throughout Europe to enhance account-ability in the credit rating industry.

In the case of Switzerland, although a registration process for CRAs has not been created in the aftermath of the financial crisis, several regulatory and legal provisions refer to CRAs. First and foremost, the FINMA has estab-lished a list of CRAs that can be used for regulatory purposes. To date the Swiss regulator has not shown any intent to move away from the regulatory use of credit ratings. Apart from that, with respect to civil liability CRAs are treated similarly to other private actors as they are subject to the general liability rules of the Swiss Code of Obligations.

As a consequence, regulatory intervention is one of the most important cat-alysts for competition in the credit rating industry, in particular since CRAs have become increasingly regulated post-crisis.

The next step entails analyzing competitive incentives in the credit rating industry. In the run-up to the 2007-2009 financial crisis, the leading CRAs competed on increasing their market share by lowering rating standards instead of focusing on rating quality.

The question arises as to whether general competition law or sector-specific regulation offers the most adequate solution to the problem. This study ar-gues that general competition law is not sufficient to solve competitive is-sues in the credit rating industry. Instead, the establishment of sector-specific regulation is necessary to take into account the particular situation of CRAs. Sector-specific regulation can more effectively attain competitive objectives.

With respect to competitive concerns, the high concentration in the credit rating industry undoubtedly plays a crucial role. It is important to analyze how the presence of an oligopolistic credit rating market affects the level of competition. Furthermore, misaligned incentives suggest that the problem did not emanate from competitive pressures but rather from ill-conceived competition. The leading CRAs did not compete on quality but on revenues

from issuers demanding inflated credit ratings. In sum, solving competitive problems requires the creation of better incentives in the credit rating indus-try. The credit rating market should be viewed as a market for information where CRAs should compete on the quality of financial information. As information intermediaries, CRAs should be willing to resolve information asymmetries by providing investors with valuable information.

PART 3: Uses and Abuses of Credit Ratings in Structured Finance

§ 7. Background

The role of the leading CRAs in structured finance ratings has given rise to significant concern in modern financial markets. In the run-up to the sub-prime mortgage crisis, CRAs attributed inflated credit ratings to mortgage-related securities that ended up performing very poorly.⁵⁸⁰ In the aftermath of the resulting rating scandals, lawmakers reformed the credit rating indus-try by means of a financial regulatory overhaul.⁵⁸¹