By Yuefen Li, Economist and Senior Advisor on South-South Cooperation and Development Finance, South Centre, Geneva
Large, established credit rating agencies (CRAs) wield immense influence and power over the global financial system and the world economy as a whole. In normal times, CRAs can significantly impact financial markets, financial-instrument issuers’ behaviors and investors’ perceptions, thus constituting a major determinant of the cost of borrowing and the direction of the money flow. During economic downturns, rating downgrades can become self-fulfilling, as herd behavior amplifies the effects of ratings. A downgrade by a major ratings agency can make or break an entire economy, as witnessed during the European debt crisis. The then prime minister of Greece accused the ratings agencies of “seeking to shape our destiny and determine the future of our children.”
The so-called “Big Three”—S&P Global Ratings, Moody’s and Fitch Ratings—collectively control approximately 96 percent of the global ratings market.
The credit-rating market resembles a cartel. The so-called “Big Three”—S&P Global Ratings (formerly Standard & Poor’s), Moody’s and Fitch Ratings—collectively control approximately 96 percent of the global ratings market and have dominated it for more than 100 years, starting in the US market and then extending to the world market. Their dominance is particularly strong in the sovereign credit-rating sector, for which they hold a global market share of around 99 percent. This means that the Big Three control the business of assessing countries’ creditworthiness.
Much criticism has arisen about this situation, including the Big Three’s inherent flaws, such as the “issuer-pays” business model, which results in conflicts of interest, lack of accountability and weakness in rating methodology. The fact that the Big Three are governed by the same regulations, all based in the same country, also reinforces the oligopoly, as they are subject to the same laws, culture and regulatory pressure. However, this monopoly may also raise questions about independence, objectivity and geopolitical bias. This oligopolistic dominance has left the competition far behind.
It is worth noting that the lack of competition in the credit-rating market may be worse than monopolies in industrial enterprises, considering the systemic influence and asymmetry of power that CRAs hold. For instance, a country’s credit rating can affect its ability to borrow, ultimately influencing its entire economic policy. The negative impact of the Big Three’s monopoly often exceeds that of many industrial monopolies. For industrial monopolies, the harm typically manifests itself in higher prices, lower innovation and reduced output. The effects are usually localized to one industrial market. However, credit-rating monopolies can affect the world’s financial system and economy, as proved by the Asian financial crisis, the European debt crisis and the subprime crisis. In the process, developing countries suffer disproportionately.
However, the Big Three’s monopoly has proved to be extremely tenacious. The CRAs have been blamed for exacerbating the Asian financial crisis. A Financial Crisis Inquiry Commission (FCIC) report concluded that the Big Three were “key enablers of the financial meltdown” that caused the Global Financial Crisis (GFC) of 2007-08. The eurozone sovereign debt crisis exposed serious flaws in sovereign ratings, such as procyclicality and cliff effect. However, the Big Three’s market share was reduced only marginally. The continued lack of open competition and the absence of alternatives seem to be the biggest problems facing the credit-rating space today, more problematic than the payment module or rating methodology.
On the other hand, the Big Three do enjoy many advantages—first-mover, scalability and network, to name a few—along with experience in the field. All of these factors make their monopoly possible. There are also two very important reasons for maintaining their dominance. Firstly, they have exploited acquisitions to expand their global reach, thereby reducing or neutralizing potentially important competition. Secondly, the United States, along with international regulations and structural decisions, has entrenched their dominance.
Historically, one important way for the Big Three to expand their market dominance has been by acquiring smaller competitors or enlarging their stakes in local CRAs in developing countries. These strategic acquisitions in recent years, especially since the early 2000s, have intensified (see news trails from Nasdaq.com). This trend aligns with the broader globalization of capital markets. As some developing countries have begun accessing international capital markets, the demand for credit ratings in emerging and developing economies has grown due to increased sovereign and corporate borrowing internationally. But with acquisitions, the Big Three do not have to create new agencies from scratch in new markets. In addition, having a local presence makes it easier for them to obtain regulatory approvals. Countries in which the Big Three have absorbed agencies include India, Argentina, Chile, Malaysia, Peru and Egypt.
Acquisitions result in a lack of alternatives for credit ratings. By examining the Big Three’s acquisition path, we see that this may be the strategic outcome they have sought. However, the lack of diversity and the absence of regional or regulatory counterbalances may also be an important global systemic risk. This is why there are calls for greater global balance—including regional CRAs, a new independent CRA, diversified oversight and multilateral frameworks.
Secondly, several US and international regulations and structural decisions in the credit-rating market have supported and entrenched the Big Three’s monopoly, creating strong regulatory barriers that make it difficult for new companies to enter the market and gain a foothold. The playing field is very much tilted and not level at all.
In 1975, the U.S. Securities and Exchange Commission (SEC) created the designation of nationally recognized statistical rating organization (NRSRO). Only the Big Three were initially granted NRSRO status. This solidified their role in regulation. This regulatory endorsement created high barriers to entry, cementing their oligopoly. Since then, USgovernment regulations and references to this status have been frequent. Certain key indices also require that a company be rated by at least one of the Big Three before being listed. These requirements effectively block new entrants to the ratings market.
After the Global Financial Crisis, the Dodd-Frank (Dodd–Frank Wall Street Reform and Consumer Protection Act) reform and new European rules on CRA supervision attempted to reduce the monopoly in the ratings market, but the lack of effective implementation measures has blunted the original objectives. The Big Three also lobbied heavily to protect their status. In the end, these reforms did not lead to increased competition in the market, and only modest regulatory changes have been implemented.
A ray of hope for more new entrants to the credit-rating market, along with a reduction in the Big Three’s monopoly, shone through with the establishment of the Africa Credit Rating Agency (AfCRA). Many African countries believe that the three major CRAs have a bias against African countries, thus leading to unduly pessimistic ratings and increased borrowing costs on international capital markets. According to estimates, such harsh ratings can cost African countries up to US$74.5 billion. Concerns about possible biases and the limitations of global agencies were the main reasons for establishing the new agency. The AfCRA does not cherish the ambition of replacing the Big Three but pragmatically hopes to complement them by providing an alternative voice or a second opinion, allowing investors to make more informed decisions. A localized view of creditworthiness is welcomed by many. Naturally, the AfCRA faces many challenges and constraints in gaining a foothold and credibility, yet welcoming more new entrants to the market is one option for challenging the concentration in the credit-rating market.
Introducing an environment that encourages competition, not stifles it, is long overdue.
Yuefen Li is an Economist and Senior Advisor on South-South Cooperation and Development Finance for the Geneva-based South Centre. Ms. Li is a former United Nations Independent Expert on Debt and Human Rights. Before joining the United Nations (UN) in 1990, she was a Lecturer at the University of International Business and Economics (UIBE) in Beijing, China.