How has the ratings game changed since the global financial crisis? Are the business models different? Has consumption of ratings changed? Have regulatory changes around ratings had any impact?
Banks bore the brunt of public ire, but the fallout from the events of late 2008 was ultimately just as grisly for credit rating agencies. Industry colossi Standard & Poor’s, Moody’s Investors Service and Fitch Ratings were, if not hobbled, then at least humbled. Why, investors, governments and regulators wanted to know, had CRAs not foreseen the destruction of so much hard economic work – and the onset of a recession from which many nations have yet to emerge – by a tiny slice of the financial sector?
Since those dark days, much has changed in an industry perpetually under pressure to adapt to the permanent revolution under way across global capital markets. Olivier Beroud, regional head, EMEA, at Moody’s, sums up the situation by highlighting “two major types of change” buffeting the industry.
“First, the emergence of new markets, and finance moving to new places,” he said. “Second, the ongoing challenge of seeking to retain both a global and a regional view while at the same time bringing transparency to a company or situation.”
The first challenge is merely the latest extension of our desire to allow money to wash from developed to developing or frontier markets, and once there, to set down strong roots. Capital then forms far from its traditional homesteads (the US and more latterly Europe) before being reinvested wherever returns are highest.
Thus, said Moody’s Beroud, “investors in Asia look at credit risk before taking a position on Turkey; Turkish investors are looking at credit risk on Russia, and so on. It’s a complex, interconnected and increasingly global process.”
It is one of those wonderful ironies that fate delivers to our doorsteps and offices, that makes securing a credit rating on your stock or bond “more important now than ever before”, said Beroud. Nor is that mere sales patter: a complex world awash with data reinforces the importance of being able to access a single source (or several trustworthy sources) able to make sense of it all.
Yet whom to choose when picking one or more agencies? Do you plump for a big-three player like S&P, or one of the smaller, national or regional players springing up around the world? Should investors, when costs permit, be augmenting CRA data and opinions with their own internal research?
The reality is that no one-size-fits-all approach exists. The post-crisis survival of the big-three CRAs has been perhaps less of a surprise than their ability to adapt and change to a new and more challenging regulatory world. Pre-crisis, the industry, said Sam Theodore, managing director, financial institutions at Scope Ratings, was “fairly unregulated”, a situation that led ultimately to “so many ratings on financial institutions in particular prov[ing] to be so spectacularly wrong”.
Yet CRAs are now as tightly regulated as any commercial lender. New rules have been slow to come, but they are now there in force. The Paris-based European Securities and Markets Authority has long been a withering critic of an industry whose biggest players handed Lehman Brothers a Single A rating a month before its collapse, and wrongly predicted Greece’s exit from the single European currency.
In August 2014, the US Securities and Exchange Commission pushed through rules to tighten controls on the industry, handing investors “powerful new tools for independently evaluating the quality” of ratings agencies, noted SEC chairwoman Mary Jo White.
The new rules, said Scope Ratings’ Theodore, gives investors “hope that they are no longer on their own facing the big agencies”.
Others are not so sure. SEC commissioner Daniel Gallagher dissented on the vote, criticising the new rules for failing to ensure ratings are not unduly influenced by the profit motive. The Chinese Walls separating sales and analytics teams at the big three are broader and taller than ever.
But a tendency to hove to the views of those that pay you the most, and instinctively to be predisposed to rate an economic world view you know and understand, based on free markets and economic liberalism, higher than one that cleaves to, say, a state-branded mode of mercantilist capitalism, will always persist.
This has long been a key argument used to expound the development of smaller, regional or domestic CRAs, such as Scope, DBRS of Canada, or Beijing-based Dagong.
Post-crisis, myriad smaller players have sought to challenge the dominance of the big three. Formed in 2002, Scope pushed into the industry in 2012 after buying a ratings specialist in Germany’s auto sector.
It now rates banks, corporates, bonds, and structured assets across real estate, aviation, and renewable energy, with the aim, said its financial institutions chief Theodore, of building “the European alternative to the big three”.
“In the past, European firms fretted that US ratings agencies didn’t understand their background or corporate culture, and that they were using US norms. Ratings agencies have reacted to that, and in the last five to 10 years, agencies have hired more European analysts. So if you go for a rating in Europe, it’s rare to be confronted by American analyst”
Scope’s strategy also differs from that of its larger US peers. Whereas analysis from Moody’s and S&P has typically continued, post-crisis, to assert ratings on, say, a peripheral eurozone lender by drawing a straight line between its credit strength and that of its sovereign, Scope adopts a different tack.
“Sovereign caps on bank ratings are not justifiable in our view, especially for banks with geographically diversified revenues,” said Theodore. The Berlin firm also leans “heavily on publicly available information, which is getting better and more widespread”, rather than relying on confidential information from issuers.
Dagong Global Credit has long been the most vocal proponent of the status quo. Its chairman, Guan Jianzhong, told IFR that it was the big three’s “poorly conceived rating system that created the [financial crisis]. Their criteria and methodologies are completely wrong. We can’t rely on them to provide impartial ratings to the world, so we need to establish a new credit rating system.”
In June 2013, it launched the Universal Credit Rating Group, a Hong Kong-based alliance with Moscow-based RusRatings, and Egan-Jones Rating.
Yet starting from scratch, or even from a position of weakness (as all ratings firms do when competing with the big three) is tricky. Scope’s ambition of becoming Europe’s big-hitter is laudable and even achievable, but only over the long term. Its heritage may help. European leaders, angered by their perception that US ratings giants are negatively predisposed to the eurozone, regularly advocate banning the CRAs from issuing sovereign ratings.
“They ask why the market is listening to us, and why our views matter,” said Moody’s Beroud. That could be a major selling point for the likes of Scope, so long as its internal rating on a eurozone nation genuinely chimes with the views of its sovereign.
Even then, it’s hard to make headway in the industry. Regulations drawn up to increase surety for investors also form obstacles for newbies. New rules, said Cecile Bidet, managing director, ratings advisory, at Societe Generale, have made it “hard for new regulatory agencies to be created as the cost of compliance has got so high”.
Then there’s the sheer irrefutable power of the industry’s leading players.
“The real impediment for smaller [ratings agencies] is the track record that we have,” said Farisa Zarin, head of government and public affairs at Moody’s. The true barrier to entry, she said, remains “the challenge of proving to customers, over a long time period, that your product is the right one”.
And even the argument that the big three fail to understand the intricacies of non-US markets – a credible view at the height of the financial crisis shared by many critics – fails, these days, to cut as much ice.
“In the past, European firms fretted that US ratings agencies didn’t understand their background or corporate culture, and that they were using US norms,” said Ernst Liehr, head of ratings advisory at Societe Generale. “Ratings agencies have reacted to that, and in the last five to 10 years, agencies have hired more European analysts. So if you go for a rating in Europe, it’s rare to be confronted by American analyst.”
Zarin joined Moody’s in 2010 at the height of the eurozone debt crisis. Since then, she said, ratings agencies have changed significantly.
”We have invested in and reviewed our internal controls,” she said. ”We have European boards and regional boards, which is a big change, and which creates certain structures that makes us more adept at engaging a more diverse world.”
Leading CRAs have also “beefed up their compliance departments”, said SG’s Bidet, “so during many discussions now you have a compliance guy on board to ensure that analysts remain within certain boundaries.” Investors have also added heft to internal research divisions, also due to the need to meet regulatory demands.
The more things change…
Few doubt that the ratings industry has changed much in recent years. Yet in one, very peculiarly human way, it has also stayed the same. That there is more information available in more formats, and on more institutions, than ever before, is undeniable.
In theory, that should benefit newcomers. Yet investors, more than ever, want something else when ploughing billions of shareholders’ dollars into a new asset, company or instrument that may equally be based down the road, on the other side of the planet. They want something that only the big three credit ratings agencies, for all the vicissitudes of recent years, can still provide. That quality, and one that will never go out of fashion, is trust.
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