The urgency to reform credit-rating agencies (CRAs) became evident with the onset of the subprime mortgage crisis in the United States. Many scholars and institutions hold the view that CRAs contributed to the subprime mortgage crisis and the subsequent global financial crisis (GFC) of 2007-08 and also escalated the European sovereign debt crisis beginning in 2009, bringing negative impacts on the economic and social situations of the countries hit by these crises. These crises have discredited CRAs and shed light on their inherent structural defects. Recently, as part of international efforts to respond to the devastating impacts of the coronavirus disease (COVID-19) pandemic, the G20 countries introduced the Debt Service Suspension Initiative (DSSI) to minimize the mounting debt-service burdens of developing countries to allow them to use more of their limited financial resources to save lives and livelihoods during the COVID-19 pandemic. However, fears of possible credit-rating downgrades have deterred the implementation of the Debt Service Suspension Initiative.1The World Bank: COVID 19: Debt Service Suspension Initiative, April 23, 2021 Some sovereign downgrades during the pandemic have also increased financial-market volatility and the difficulties of these countries to access new sources of financing. This has once again drawn international attention to the need to reform credit-rating agencies.
CRAs systemically important but unregulated before the US subprime mortgage crisis
Credit-rating agencies play a crucial role in the international financial system. Governments and enterprises need to borrow money for various purposes, and they require professional, credible and objective third parties to act as bridges between lenders and borrowers, reducing the information asymmetry by providing objective, independent and expert information on issuers and borrowers of bonds and other debt instruments and fixed-income securities. This is the role that CRAs are expected to play. With the exploding of public and private debt over the past decades and with bonds becoming increasingly important in the composition of sovereign and private debt, the business of CRAs has been snowballing fast. Credit rating has become a large international business. However, paradoxically, this business has been dominated by three large US private agencies, namely Standard & Poor’s Global Ratings, Moody’s Investors Service and Fitch Ratings, which together form an oligopolistic position for rating in private and public-debt markets.2Moody’s Analytics: “ESMA Publishes Market Share Figures for Credit Rating Agencies in EU” and U.S. Securities and Exchange Commission: Annual Report on Nationally Recognized Statistical Rating Organizations, Page 15, December 2018
Even more ironically, prior to the subprime mortgage crisis of the United States, CRAs were essentially unregulated by the US federal government.3U.S. Securities and Exchange Commission: Testimony Concerning Oversight of Nationally Recognized Statistical Rating Organizations, Chairman Christopher Cox, April 22, 2008 The Credit Rating Agency Reform Act of 2006 passed by the United States Congress recognized, for the first time, that CRAs are of national importance. As a matter of fact, they are of international importance since many of their ratings have been for entities operating in the other continents of the world. Credit ratings not only influence investors’ portfolio-allocation decisions but also the pricing of debt instruments—e.g., the interest rates for debt to be repaid. Therefore, CRAs are market-makers and movers and have significant impacts on the allocation of financial resources and cost of capital. If indeed CRAs can provide expert, independent, objective and forward-looking information, they would play the role of preventing debt crises through guiding investment decisions to avoid overborrowing and also assist with debt-crisis resolution through smoothening capital flows for countries facing temporary liquidity problems. Their risk analyses and evaluations at country and enterprise levels, if done properly, should forewarn of a debt crisis and contribute to debt-crisis prevention. However, CRAs have been criticised as the fire alarm that never rang. One major reason for this phenomenon is that CRAs have suffered from birth defects and other structural weaknesses.
Birth defects of CRAs
Credit-rating agencies suffer from birth defects, including conflicts of interest. Their business model of debt-instrument-issuers paying for their credit ratings is at the heart of those conflicts of interest. To give credit-rating judgments to the very clients who pay them to do the job is clearly a solid reason for doubting the ability of CRAs to give objective assessments. To be paid by the people whom they judge seems to be a massive conflict of interest. Who would chop off the hands that feed them? What is the probability of CRAs not being influenced by financial, political and customer relationship pressures? It is even more insane to believe in their objectivity when CRAs were themselves partners in the design of the same investment products—or financial engineering of instruments such as mortgage-backed securities—that they rated before the subprime mortgage crisis, reaping huge profits from the instruments they themselves had rated as triple-A. Therefore, CRAs have, in many cases, been paid for their positive ratings. It is documented4The Big Short: Inside the Doomsday Machine, Michael Lewis, 2011 that CRAs continued to give bonds triple-A ratings even when the prices of these securities had started to fall. It is natural that CRAs have been accused of contributing to the global financial crisis together with investment banks, setting back many economies around the world by a decade.
One study5“Bank ratings: what determines their quality?”, Economic Policy, Volume 28, Issue 74, Pages 289-333, Harald Hau, Sam Langfield and David Marques-Ibanez, April 2013 based on 39,000 quarterly bank ratings from the period 1990–2011 from Moody’s, S&P and Fitch found that large banks obtain systematically more favourable ratings. Apparently, CRAs do heed their relationships with their large customers.
The Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System (known as the Stiglitz Commission)6United Nations: Press Conference by Joseph Stiglitz, Chairman, Experts Commission on International Monetary and Financial System Reforms, June 25, 2009concluded that “the credit rating system is ineffective and plagued with conflicts of interest”. The US SEC’s (U.S. Securities and Exchange Commission’s) annual report of 2016 expressed concerns about the conflicts of interest and structural problems giving rise to the possibilities of external influence on rating analyses and opinions as well as evidence of errors and low quality of ratings.7U.S. Securities and Exchange Commission: 2016 SUMMARY REPORT OF COMMISSION STAFF’S EXAMINATIONS OF EACH NATIONALLY RECOGNIZED STATISTICAL RATING ORGANIZATION, December 2016
A business dominated by an oligopoly
The credit-rating market is highly monopolized by three agencies, namely Standard & Poor’s, Moody’s Investors Service and Fitch Ratings—which also have cross-holdings of shares among them, forming an oligopolistic position in the market of rating private and public debt.8U.S. Securities and Exchange Commission: Annual Report on Nationally Recognized Statistical Rating Organizations, Page 15, December 2015. Although there are some smaller credit-rating agencies worldwide, according to the U.S. Securities and Exchange Commission’s December 2015 Annual Report on Nationally Recognized Statistical Rating Organizations, the Big Three controlled 95.8 percent of outstanding credit ratings at the end of 2014.9U.S. Securities and Exchange Commission: Annual Report on Nationally Recognized Statistical Rating Organizations, Page 12, December 2015 According to Moody’s Analytics’ “ESMA Publishes Market Share Figures for Credit Rating Agencies in EU” (November 29, 2019): “The results show that the three largest CRAs—S&P Global Ratings, Moody’s Investors Service and Fitch Ratings—account for 92.1 percent of the market for credit rating agencies in [the] EU, representing a 2.7 percent increase on 2018. The remaining 7.9 percent of the market is shared between the other 23 CRAs that are registered in [the] EU.”
The three agencies are de facto private and profit-seeking companies. However, since 1975, following the introduction of new rules by the U.S. Securities and Exchange Commission, they have been recognized as “official” rating agencies and each named as a nationally recognized statistical rating organization (NRSRO). This status has elevated their profiles and importance while giving more credibility to their judgments. In addition, this status has further strengthened and maintained their oligopoly by making market-entry barriers more formidable, thus reducing the possibility for the entrance of small- and medium-sized competing companies.10“What’s (still) wrong with credit ratings?”, Washington Law Review, San Diego Legal Studies Paper, No. 17-285, Frank Partnoy, 2017
The lack of competition and the privileged position these agencies enjoy appear to give the Big Three too much comfort and too little incentive to strive to hand out objective and quality judgments of sovereign and private borrowers.
Procyclical ratings and their negative impacts
The ratings of CRAs tend to be lax or over-optimistic at the top of the economic cycle and over-severe and brutal at the bottom of the business cycle. Procyclical ratings could encourage over-borrowing during good times and deepen a debt crisis during bad times.
In the cases of the Asian Financial Crisis11“The procyclical role of rating agencies: Evidence from the East Asian crisis,” Economic Notes, G. Ferri, L.-G. Liu and J.E. Stiglitz, December 2003 of 1997, global financial crisis of 2007 and European debt crisis of 2009,12Council on Foreign Relations: “The Credit Rating Controversy.” there was evidence of over-optimistic ratings and at times completely wrong public statements and warnings, which fueled the pre-crisis lending boom and capital inflows and resulting asset bubbles in some cases. Then, when the crises set in, there were waves of fast credit downgrades, which contributed to abrupt sell-offs of securities (cliff effects), massive capital outflows and losses of access to capital markets by enterprises and sovereigns. These actions have exacerbated financial-market volatility and made governments’ efforts to contain debt crises ineffective, as well as increasing human suffering. This is particularly evident in the case of Greece during the European debt crisis. As for the 2007 global financial crisis, economists and regulators hold the view that CRAs’ failures and mistakes were the main reasons for the crisis. The assessment of the U.S. Senate Permanent Subcommittee on Investigations was that “inaccurate AAA credit ratings introduced risk into the U.S. financial system and constituted a key cause of the financial crisis”. The CRAs’ over-positive but wrong ratings made investors believe that the mortgage-backed products were riskless. People were not aware that CRAs themselves completed the financial engineering together with investment banks. Even so, when the crisis hit, the CRAs followed the same pattern of launching a downward spiral of negative ratings, which worsened the spread of the crisis. Then, by the beginning of 2008, after the crisis hit, most of their AAA-rated residential mortgage-backed securities were downgraded.13“U.S. Subprime RMBS 2005-2007 Vintage Rating Actions Update: January 2008,” Moody’s Investors Service, February 1, 2008; “Transition Study: Structured Finance Rating Transition And Default Update As Of March 21, 2008,” Standard & Poor’s Ratings Services, March 28, 2008; “U.S. RMBS Update,” Fitch Ratings, February 20, 2008
With memories of the quick-fire downgrades of Greece, Ireland, Portugal and other countries in the European debt crisis, the European Securities and Markets Authority (ESMA) has cautioned CRAs against deepening the coronavirus crisis through quick-fire downgrades of countries and push pandemic-hit economies into deeper recessions.14S&P Global Market Intelligence: ESMA urges rating agencies to avoid quick-fire downgrades amid crisis – Reuters, Mary Christine Joy, April 10, 2020
During the COVID-19 pandemic, according to the “Africa Sovereign Credit Rating Review”15African Union: “Africa Sovereign Credit Rating Review,” June 2020 report produced by the African Peer Review Mechanism (APRM)—an entity of the African Union (AU)—in collaboration with the African Development Bank (AfDB) and the United Nations Economic Commission for Africa (UNECA), 11 countries saw their sovereign credit ratings downgraded in the first half of 2020 and 12 countries had their outlooks changed to negative by different CRAs.
The timing of rating actions should be carefully calibrated during crises and take into consideration social and human-rights factors. Human capital is one of the most important factors of productivity, which means lack of concern for social rights could lead to long-term losses of economic growth and the worsening of debt problems down the road. That is a major reason for awarding regulators direct oversight of credit-rating agencies during crises. The most recent case was during the 2008 global financial crisis when sovereign downgrades were suspended to avoid worsening the European debt crisis.
Procyclical downgrades result in self-fulfilling prophecies of debt crises. CRAs’ downgrades and negative statements, in most cases, can shift the sentiments of capital markets towards a debtor; sometimes, the multiplier effect can be triggered overnight. The self-fulfilling prophecy effect often wipes out the efforts made by governments to resolve debt problems.
Lack of accountability
CRAs are not held accountable for their inaccurate or wrong ratings on the grounds that the credit ratings of debt instruments are considered opinions, not judgments.
Therefore, CRAs have been shielded from liability by the First Amendment to the United States Constitution, ensuring “the freedom of speech”even though this kind of speech or opinion has the power to create volatility in financial markets, including massive capital inflows and outflows for developing countries in particular. With this accountability gap, investors and borrowers cannot be protected from mistakes made by credit-rating agencies or any abuse of power by these agencies. The Dodd-Frank Wall Street Reform and Consumer Protection Act required the U.S. Securities and Exchange Commission to hold CRAs to the same standard of “expert liability” that auditors and lawyers face. But CRAs protested and threatened to freeze ratings. Subsequently, the Commission decided to postpone the enforcement of the rule temporarily.16“Analysis: Credit agencies remain unaccountable,” USA Today, Kathleen Day, May 19, 2014
The reform of CRAs would require restructuring the international financial architecture—including addressing the CRAs’ inherent problems, such as the “issuer pay” business model, conflicts of interest and the opacity of the agencies’ decision-making.
Recent crises have highlighted the tremendous importance of ensuring that credit-rating agencies play their roles properly. Therefore, it is not surprising that many proposals about reforming CRAs have been put forward over the years. However, most of these proposals have run into various challenges and resistances. Thus far, little progress has been made in reforming the CRAs, and most of the reform proposals have been either stalled or shelved completely. Current existing regulations have not fundamentally altered the market structure for CRAs, including the massive conflicts of interest. Yet, the importance of credit rating has not diminished, as demonstrated by the difficulties encountered in the implementation of the G20’s Debt Service Suspension Initiative. Urgent reform of credit-rating agencies is needed and should be taken as part of the broader reform of the international financial architecture, including debt-crisis prevention and resolution.
1 The World Bank: COVID 19: Debt Service Suspension Initiative, April 23, 2021.
2 Moody’s Analytics: “ESMA Publishes Market Share Figures for Credit Rating Agencies in EU” and U.S. Securities and Exchange Commission: Annual Report on Nationally Recognized Statistical Rating Organizations, Page 15, December 2018.
3 U.S. Securities and Exchange Commission: Testimony Concerning Oversight of Nationally Recognized Statistical Rating Organizations, Chairman Christopher Cox, April 22, 2008. (https://www.sec.gov/news/testimony/2008/ts042208cc.htm)
4 The Big Short: Inside the Doomsday Machine, Michael Lewis, 2011.
5 “Bank ratings: what determines their quality?”, Economic Policy, Volume 28, Issue 74, Pages 289-333, Harald Hau, Sam Langfield and David Marques-Ibanez, April 2013.
6 United Nations: Press Conference by Joseph Stiglitz, Chairman, Experts Commission on International Monetary and Financial System Reforms, June 25, 2009. (https://www.un.org/press/en/2009/090625_Stiglitz.doc.htm)
7 U.S. Securities and Exchange Commission: 2016 SUMMARY REPORT OF COMMISSION STAFF’S EXAMINATIONS OF EACH NATIONALLY RECOGNIZED STATISTICAL RATING ORGANIZATION, December 2016. (https://www.sec.gov/ocr/reportspubs/special-studies/nrsro-summary-report-2016.pdf)
8 U.S. Securities and Exchange Commission: Annual Report on Nationally Recognized Statistical Rating Organizations, Page 15, December 2015. (https://www.sec.gov/files/2017-02/2015-annual-report-on-nrsros.pdf)
9 U.S. Securities and Exchange Commission: Annual Report on Nationally Recognized Statistical Rating Organizations, Page 12, December 2015. (https://ww.sec.gov/files/2017-02/2015-annual-report-on-nrsros.pdf)
10 “What’s (still) wrong with credit ratings?”, Washington Law Review, San Diego Legal Studies Paper, No. 17-285, Frank Partnoy, 2017.
11 “The procyclical role of rating agencies: Evidence from the East Asian crisis,” Economic Notes, G. Ferri, L.-G. Liu and J.E. Stiglitz, December 2003.
12 Council on Foreign Relations: “The Credit Rating Controversy.”
13 “U.S. Subprime RMBS 2005-2007 Vintage Rating Actions Update: January 2008,” Moody’s Investors Service, February 1, 2008; “Transition Study: Structured Finance Rating Transition And Default Update As Of March 21, 2008,” Standard & Poor’s Ratings Services, March 28, 2008; “U.S. RMBS Update,” Fitch Ratings, February 20, 2008.
14 S&P Global Market Intelligence: ESMA urges rating agencies to avoid quick-fire downgrades amid crisis – Reuters, Mary Christine Joy, April 10, 2020. (https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/esma-urges-rating-agencies-to-avoid-quick-fire-downgrades-amid-crisis-reuters-57982524)
15 African Union: “Africa Sovereign Credit Rating Review,” June 2020. (https://au.int/sites/default/files/documents/38809-doc-final_africa_scr_review-_mid_year_outlook_-_eng.pdf)
16 “Analysis: Credit agencies remain unaccountable,” USA Today, Kathleen Day, May 19, 2014. (https://www.usatoday.com/story/money/business/2014/05/19/credit-rating-agencies-in-limbo/9290143/)