Examining the Credit Agencies: The More They Compete, the Higher Their Ratings

A new working paper* from Harvard supports the claim that increased competition among credit ratings agencies has resulted in more generous and less informative ratings.

The paper examines the impact of the growth of Fitch Ratings as a competitor to the incumbent “duopoly” of rating agencies Standard & Poor’s and Moody’s (MCO). Over the decade starting in the mid-1990s, Fitch’s share of corporate bond ratings issued increased from around 10% to approximately one third of the market, according to the paper.

The authors cite three pieces of evidence, which they say are all more or less consistent with a reduction in credit rating quality:

• First, competition is associated with friendlier ratings (i.e., they are closer to AAA).
• Second, ratings and bond yields have become less correlated (conditional on public information about bonds and issuers).
• Third, at least in the short run, equity prices react more to downgrades as competition increases, consistent with a lowering of the bar for ratings categories. This is especially clear for downgrades from investment grade to junk status.

The economic magnitudes we find are moderate but nontrivial, the authors write.

“Conservatively, we find that a rise in competition corresponding to a one standard deviation increase in Fitch’s market share is predicted to increase the average firm and bond rating by 5-10% of a rating step (and increase it significantly more for more highly-levered firms), to reduce the conditional correlation between ratings and bond yields by about a sixth compared to the case when Fitch has no market share, and increase the negative equity price responses to downgrades by a quarter or more.”

The authors suggest that regulators consider that increasing competition in the ratings industry involves the risk of impairing the reputational mechanism that underlies the provision of good quality ratings. There may obviously be benefits of competition in other areas  Nevertheless, calls for more competition, such as by the U.S. Department of Justice (1998), may deserve a caveat.

For bond markets, it is clear that relying on third party ratings paid for by issuers is not a system without risks. Our empirical findings suggest that the system will work better when competition is not too severe.

*Reputation and competition: evidence from the credit rating industry (by Bo Becker and Todd Milbourn, Harvard University and Washington University, St Louis.)

Comments

[Nick Gogerty:]

good article. the credit agencies are part of the systemic reason behind the current "normal accident" eliminating the credit agency monopoly status via the NRSRO regulatory regime would counterintuitively lead to a more robust system.

when flying a plane, the only thing more dangerous than having no instruments is overly relying on a fualty one.

2008 Oct 17 12:03 PM

[kingaj12:]

Very important issue -- but it is probably a tendency that can be predicted by investors and regulators.

The more serious issue is when Ratings Agency policies contribute to procyclic tendencies in the ABS market. See Ashcraft and Schuermann : papers.ssrn.com/sol3/p...

2008 Oct 22 09:50 AM