This week has been the MaCCI competition and regulation day–a small internal workshop by the people of the Mannheim Center for Competition and Innovation with a lot of interesting papers. The distinct feature about MaCCI is that it brings together economists and law scholars to discuss topics from an interdisciplinary point of view. Ulrich Schroeter, professor for private and financial markets law, gave a talk about the market for credit ratings and problems of regulating it.
A common perception is that we have too few competition in the ratings market which is highly concentrated and dominated by three players: Standard & Poor’s, Moody’s, and Fitch. Part of the reason why the market is so concentrated, people believe, is that many financial instruments require a credit rating by a legally certified agency, otherwise they cannot be traded. In the past there were simply not that many certified agencies out there so competition was naturally low.
However, Schroeter argues that for the special business model of credit rating agencies (CRA) competition in a market might not be that good for rating quality. Since ratings are requested by, let’s say, the issuer of a bond himself, and then made public, a larger number of competitors leaves room to choose exactly the agency that treats a company most favorably. Agencies, to secure market shares, might simply inflate ratings to please customers. Schroeter backs this story with a case study about a particular market for bonds of German small and medium-sized businesses that was established in 2010.There you see a lot of small and local agencies operating and the ratings, according to Schroeter, are usually quite bad.
Frankly speaking, this story is hard to digest for an economist. “Agency shopping” is clearly something that could go on. But the few data that Schroeter presented is not able to discriminate between other possible explanations. Also, the special market looked at is quite young. CRA’s have an incentive to establish a good reputation over time. So things could improve once these small players work on the quality of their methods to assess risk.
Anyhow, let’s believe the “agency shopping” story for a moment and that it’s the fundamental driver of bad ratings. An economist would then immediately conclude that we should regulate the market such that we only allow for a monopoly of one agency; possibly by the state. At least Schroeter must have heard this comment before because he was prepared to it. He claimed that this might be desirable from a theory point but most certainly also unconstitutional. Simply because informing the public about your perception about the credit default risk of a company is protected by freedom of speech and the press in most countries. I certainly didn’t know that it goes that far with the basic right for operating a CRA.
One last point about the presentation was noteworthy. The freedom of the press protects CRAs but Europe has been not that strict with these constitutional constraints in recent years. In the EU an agency has to be certified otherwise it isn’t even allowed to publish a rating. Such a rule would most likely not survive the Supreme Court in the US. There, if you’re not legally certified, your rating cannot be used to comply to certain regulatory standards requiring credit ratings. But everybody is free to say whatever she pleases about a company’s solvency.
And it goes even further. Europeans seem to be very suspicious and somehow fed up with the business of (US-based?!) rating agencies. In May 2013, the EU adopted an amendment* to the “Regulation (EC) No 1060/2009 on credit rating agencies” that prohibits agencies rating sovereign risk to give any policy recommendations to evaluated countries. Paragraph 45 of the amendment reads:
“For the purpose of transparency, when publishing their sovereign ratings, credit rating agencies should explain in their press releases or reports the key elements underlying those credit ratings. However, transparency for sovereign ratings should not be conclusive to the direction of national policies (economic, labour or other). Therefore, whilst those policies may serve as an element for the credit rating agency to assess creditworthiness of a sovereign entity or its financial instruments, and may be used in explaining the main reasons for a sovereign rating, direct or explicit requirements or recommendations from credit rating agencies to sovereign entities as regards those policies should not be allowed. Credit rating agencies should refrain from any direct or explicit policy recommendations on policies of sovereign entities.”
Infringement can cause a fine up to €750,000. Clearly these rules were adopted because of the European sovereign debt crisis and some countries did not agree with reforms that may have been suggested by rating agencies. Although you can still downgrade a rating because of bad policies and communicate that accordingly, I would expect that because of the high fines and the legal uncertainty about what is still an “explanation of sovereign ratings” and what is already an explicit policy recommendation” CRAs will refrain from pointing to any necessary reforms. In light of freedom of the press I don’t think that silencing the market in that way is particularly helpful.