The Credit Rating Agencies Between Crisis and Resurrection of International Finance Problems and Perspectives

1. The Credit Rating Agencies Between Crisis and Resurrection of International FinanceProblems and Perspectives by Giovanni Ferri & Punziana Lacitignola (University of Bari – Italy) [Lezione 10 del corso di Economia delle scelte di portafoglio] Presentation largely drawn on Ferri-Lacitignola Le agenzie di rating tra crisi e rilancio della finanza globale, Bologna, Il Mulino, 2009.

2. Key Questions in Presentation: • Why are Credit Rating Agencies (CRAs) key to capital markets? • Set up (industry structure & regulation) of the Global CRAs (Moody’s; S&P; Fitch;DBR) • Main allegations of the literature on GCRAs: some are grounded in the evidence • Are GCRAs enough for capital market development or do we need Regional CRAs? (Europe vs. Asia) • How about GCRAs specializing in multinationals & Regional CRAs in smaller-sized regional issuers? • National CRAs & the development of national financial markets • CRAsresponsibility and regulation matter

3. Why are CRAs key to capital markets? • Ratings are an essential lubricant for financial markets as they reduce information asymmetry that investors undergo vis-à-vis issuers; they determine the cost of borrowing • Though perfectible (see below) ratings greatly enhance market information on issuers: unexpected rating changes affect level-volatility of bond-share price (Kliger & Sarig 2000) and credit default swaps (Hull et al. 2004; Norden and Weber 2004); bond downgrades cause negative abnormal stock returns (Dichev & Piotroski 2001, Ferri & Lacitignola, 2007) • Boot et al. (2004): in multiple equilibria states the rating is a coordinating mechanism, providing a “focal point” for firms and investors, thanks to the implicit contract relationship (monitor-renegotiate) but Carlson & Hale (2004) reach opposite conclusions

4. Set up of the Global CRAs – 1 • Origin of the GCRAs • Interaction with financial markets • Regulatory evolution • Industrial organization of GCRAs • Some description of GCRAs’ ratings • Origin of the GCRAs (Sylla, 2001) First rating in 1909 by John Moody: US financial markets needed certification after 1907 crisis

5. Set up of the Global CRAs – 2 • Interaction with financial markets To reduce information asymmetries in financial markets, CRAs issue credit ratings on sovereigns, other public entities, banks, corporates and structured finance (SF) products. The rating is an estimate of the issuer’s ability to honor its future interest and capital payments For issuers, ratings affectinterest rate spreads (Ederington et al, 1987; Sy, 2002; Gonzalez at al, 2004) & the extent of available investment flows To the latter extent, it is key whether the rating is investment grade or not (speculativegrade) Are corporate & SF ratings different? (Violi, 2004)

6. Set up of the Global CRAs – 3 • Interaction with financial markets (cont’d): Rating Scale

7. Set up of the Global CRAs – 4 • Regulatory evolution 1931 US Treasury Department: bonds with a rating below investment grade (i.e. below BBB) must be posted with a value below purchasing cost 1936 Banking Act: no holding of below BBB bonds 1975 SEC Regulation 15c3-1 establishes: (i) higher capital requirements for financial firms holding bonds with a rating below BBB; (ii) list of Nationally Recognized Statistical Rating Organizations (NRSROs: Moody’s, S&P, Fitch and, from 2003, Dominion Bond Rating - DBR) 2004 Basel Regulation of bank minimum capital: standard approach hinges on ratings Ongoing: • SOX-mandated SEC assessment & partial opening of NRSRO list; • Current discussion

8. Set up of the Global CRAs – 5 • The industrial organization of GCRAs Moody’s: (founded 1909) Gross income ($ billion): 1.2 in 2009; 1.19 in 2008; 1.63 in 2007; 0.6 in 2000 Net income ($ million): 402 in 2009; 457 in 2008; 701.5 in 2007; 289 in 2002: 66% from US, 23% from Europe Over 30,000 rated entities (sovereigns, banks & corporates) 1,700 employees of which 1,000 analysts. S&P: (founded 1917; in McGraw-Hill group 1966) In 2008 alone, Standard & Poor's Ratings Services published more than 1,150,000 ratings, including new and revised ratings; 8,500 employees; it covers 70% of global market capitalization.

9. Set up of the Global CRAs – 6 • The industrial organization of GCRAs (cont’d) Fitch: (founded 1913, merged with IBCA in 1997) Net income (€ million): 350; 3,000 ratings on Sovereigns, Banks & Corporates; 1,200 employees of which 700 analysts. DBR: (Canada based, NRSRO since 2003) Other NRSRO agencies: A.M. Best (2005), R&I (2007), JCR (2007), Egan-Jones (2007), LACE (2008), Realpoint (2008) • GCRAs are very profitable: pundits accuse NRSRO regulatory franchise

10. Set up of the Global CRAs – 7 • Description GCRAs’ ratings (BCBS, 2000): Banks

11. Set up of the Global CRAs – 8 • Description GCRAs’ ratings: Corporates

12. Set up of the Global CRAs – 9 • Description GCRAs’ ratings: Structured Finance

13. Set up of the Global CRAs – 10 • Some description of GCRAs’ ratings • Highly concentrated industry with Moody’s and S&P playing as leaders (US Dept of Justice labeled it “partner monopoly”), Fitch and DCR as distanced followers [Norden & Weber (2004): reviews for downgrade by S&P and Moody’s have largest impact on credit default swaps and shares]; • Though bank ratings are also important, the bulk of GCRAs’ business is in corporates and structured finance • GCRAs’ business is for almost ¾ US based with bank ratings more geographically widespread

14. Set up of the Global CRAs – 11 • M&A of GCRAs increased concentration • In 2000 Fitch buys DCR, Thomson BankWatch; • Looking at ratings in emerging economies • Differences across regions of the world: GCRAs’ penetration is highest in Europe, smallest in Asia, intermediate in Latin America and Africa • The number of ratings is much larger in Asia (and Latin America), where GCRAs’ penetration is lower, than in Europe • GCRAs moving from branches to subsidiaries

15. Set up of the Global CRAs – 12

16. Set up of the Global CRAs – 13

17. Set up of the Global CRAs – 14

18. Set up of the Global CRAs – 15

19. Set up of the Global CRAs – 16

20. Set up of the Global CRAs – 17

21. Set up of the Global CRAs – 18

22. Main allegations on GCRAs – 1 GCRAs’track record: • US: best (some exceptions); other OECD: good; Emerging Countries: not so good/evolving • Main complaints for ratings outside US: • Too late • Pro-cyclical • Private ratings too linked to sovereigns’ • Lower info quality of private ratings • GCRAs under-invest in info processing • Anticompetitive practices & conflicts of interest

23. Main allegations on GCRAs – 2 • Too late: GCRAs followed the market rather than forewarn it in the Asian financial crisis (IMF, 1999; BIS, 1999; Bhatia, 2002) [& Enron, Worldcom etc.] On GCRAs’ failures, Bhatia (2002) notices that: (i) sovereign ratings result from one-size-fits-all ranking process; (ii) improvement in methodology/disclosure after the EA crisis may wish well for the future Bissoondoyal-Bheenick (2004): generally, private rating changes have little/no market impact Bongini et al (2002): stock prices & ratings did not outpace backward looking balance sheet information to assess bank fragility in the EA crisis

24. Main allegations on GCRAs – 3 • Too late: GCRAs follow the market (cont’d) Sovereign downgrades follow (rather than lead) currency crises but do better at predicting defaults (Reinhart, 2002; Sy, 2004) → currency instability raises default risk (Reinhart, 2002 but not Sy, 2004); downgrades of structured products done after markets collapsed

25. Main allegations on GCRAs – 4 • Pro-cyclical: Late recognition of problems may lead GCRAs to downgrade emerging countries (both sovereigns & companies) excessively vis-à-vis what deserved by their fundamentals  so GCRAs may exacerbate cycles & downturns in emerging countries • Macro evidence: Monfort & Mulder (2000); Mulder & Perrelli (2001); Ferri, Liu & Stiglitz (1999); Kaminsky & Schmukler (2002); Kräussl (2003) [but: Mora (2004) questions some of this evidence for the EA crisis pointing to rating stickiness (in line with a conservative hypothesis, Löffler 2004); Hu et al. (2004): sovereign ratings were insufficiently conservative before the Asian and Russian crises]

26. Main allegations on GCRAs – 5 • Pro-cyclical: (cont’d) • Reisen & von Maltzan (1999) are among the first authors to argue about the boom & bust cycle triggered by procyclical sovereign ratings • Zhang (2003): GCRAs had assigned over-generous ratings to Argentina, & their downgrade lagged market • Block & Vaaler (2004) find that GCRAs downgrade developing countries more often in election years as viewing elections negatively, raising developing democracies’ cost of capital • Wei (2003) proposes a new multi-factor methodology to come up with a-cyclical ratings; because of assumptions he is criticized by Amato & Furfine (2004): for all US firms rated by S&P they find that ratings do not generally exhibit excess sensitivity to the business cycle.

27. Main allegations on GCRAs – 6 FLS99: Pro-cyclical sovereign ratings in Asia

28. Main allegations on GCRAs – 7 • Private ratings too linked to sovereigns’ • Sovereign downgradescause firm-level downgrades (that are sticky to sovereign upgrades instead) only in emerging economies via a ‘domicile effect’ (Nickell et al. 2000), possibly excessive sovereign downgrades exert a negative impact on the cost of capital for emerging economies’ private sector and the new Basel criteria will amplify this impact (Ferri-Liu-Majnoni, 2001)

29. Main allegations on GCRAs – 8 FLM01:Asymmetric impact of sovereign downgrades

30. Main allegations on GCRAs – 9 • Lower info quality of private ratings A lot of asymmetry in determinants of firm ratings in developed vs. emerging countries: firm specific risk dominates/sovereign risk negligible for developed countries’ firms while the opposite holds for emerging countries information content of firm ratings is much smaller in emerging countries (Ferri & Liu, 2003)

31. Main allegations on GCRAs – 10FL03: Asymmetry in firm ratings

32. Main allegations on GCRAs – 11 • GCRAs under-invest in emerging countries: Vis-à-vis developed countries, fewer analysts for sovereigns ( absolute under-investment) and firm ratings positively related to the number of analysts while the opposite holds for developed countries’ firms  relative under-investment in emerging countries (Ferri, 2004; Ferri & Liu, 2004, using data from Moody’s)

33. Main allegations on GCRAs – 12 FL04:Absolute under-investment for sovereigns

34. Main allegations on GCRAs – 13 FL04:Relative under-investment for firms

35. Main allegations on GCRAs – 14 • Anticompetitive practices & conflicts of interest • Sometimes GCRAs promote their business via questionable unsolicited ratings (revised up only if the company pays its fee). Dumping practice to conquer foreign markets (home market is protected by NRSRO regulation)? Poon (2003): unsolicited ratings for Japanese issuers lower than solicited ratings even controlling for differences in sovereign risk & key financial ratios of the rated entity. Issuers looks for better rating among CRAs (rating shopping, Skerta &Veldkamp, 2009) • Issuers of securities pay for credit ratings a fee based on the size of issue → potential conflict of interest (Burnie & Langsam 2004); Covitz & Harrison (2003): no evidence of conflict of interest

36. Main allegations on GCRAs – 15 • Anticompetitive & conflict of interest (cont’d) - Sometimes private contracts contain “NRSRO rating triggers” causing adverse consequences, such as the shortening of debt repayment schedules → since the trigger is usually around the investment grade threshold, this may induce the rating agency to be reluctant to downgrade Johnson (2003): compares downgrading actions by an NRSRO CRA vs. a non-NRSRO CRA at the investment grade threshold, the data suggest the former hesitates (vis-à-vis the latter) to downgrade issuers to speculative grade

37. Main allegations on GCRAs – 16 • Anticompetitive & conflict of interest (cont’d) Failure at rating structured products is blatant: e.g. Jul 1st - Aug 31st 07 S&P downgraded 1,544 securities guaranteed by resid. mortgages • How much of this was due to the fact that the history of these products was too short to allow rating them? • How much, instead, was due to conflicts of interests as the agencies were involved in both consulting and rating structured finance?

38. Main allegations on GCRAs – 17 For extreme chastising views on GCRAs see: Partnoy (1999): “the reputational capital view of credit rating agencies is not supported by history or economic analysis. Credit rating agencies have not survived for six decades because they produce credible and accurate information. They have not maintained good reputations based on the informational content of their credit ratings. Instead, the credit rating agencies have thrived, profited, and become exceedingly powerful because they have begun selling regulatory licenses, i.e., the right to be in compliance with regulation. Credit ratings therefore are an excellent example of how not to privatize a regulatory function … Never has too little, too late, been so powerful” White (2001) demands full liberalization dropping NRSRO list

39. Main allegations on GCRAs – 18 For a more balanced view on GCRAs see Hill (2004): Rating agencies certainly didn’t do a spectacular job with Enron, but there is considerable evidence that in the normal course, they do a good, if not stellar, job. … The main problems regulatory change could address are those resulting from market concentration. The price of ratings may not be as low, and the quality of ratings may not be as high, as would be the case if the industry were more competitive. But the rating agencies are not completely unconstrained as to price or quality. Potential competition serves as a constraint, as does the specter of increased regulatory scrutiny. The SEC should permit provisional, location-specific, and industry specific NRSRO designations … Notwithstanding any efforts the SEC makes … with size and age conferring significant advantages, it’s not easy for a new rating agency to be established or gain a significant presence in the market. Recognizing that the market may still remain quite concentrated, regulatory reform should also encourage rating agencies to be more responsive to the needs of market participants. … creation of a public forum in which market participants would comment on rating agencies’ performance (accountability through voice). Annual certification by rating agencies that they are operating in accordance with procedures to guard against conflicts of interest.

40. Regional CRAs & capital market development 1 In light of the shortcomings of the GCRAs & of the fact that they are even less accountable abroad than in the US market, one may ask whether Regional CRAs are needed for capital market development Answers differ between Europe vs. Asia: while in Europe short-lived national credit rating agencies were sooner or later acquired by the GCRAs, many Asian countries still have their own national credit rating agencies, even if no truly regional agency exists yet Specifically, Japan has the 2 largest & long lived

41. Regional CRAs & capital market development 2 How do the Regional CRAs compare to GCRAs? Japanese CRAs often accused of being too lenient to local issuers with respect to GCRAs, but: BCBS(2000): Outside of the US, Japanese rating agencies are among the oldest and most active. Data availability has thus attracted the attention of researchers. In this case, analysis has uncovered some fairly large differences between Japanese agencies and non-Japanese agencies, which seem to be tougher on the local issuers. Nevertheless, there may be fewer differences across agencies about relative riskiness, as there is evidence that both Japanese and non-Japanese ratings are highly correlated with market-determined credit spreads. [This was already pointed out by Kawai (1997), Packer & Reynolds (1997), Packer (2000)]

42. Regional CRAs & capital market development 3 In recent years, Japanese CRAs have been awarded prizes (over & above GCRAs) by JP Morgan for their work on the Samurai bond market Shin & Moore (2003): find a systematic bias upward for the two Japanese rating agencies (RAs) and show the bias cannot be explained by keiretsu belonging; however, when they estimate a rating determination equation the discriminating power of the Japanese RAs as measured by the adj R2 is no lower than for Moody's or S&P Do national companies perceive a difference between GCRAs & Regional CRAs? (JCIF survey, 2001)

43. Regional CRAs & capital market development 4

44. Still shallow EU financial mkts: 1995 vs. 2005 • post EMU progress of Euroland private securities markets lower than expected (Hartmann et al. 2003; Cappiello et al. 2006) • The rest is drawn from Ferri & Lacitignola (2007) University of Bari

45. Various factors may promote the development of private bond markets: By removing exchange rate risks, EMU was a main promoting factor ... but it’s not the only one ... Asset management seeking diversification and higher return Better market infrastructure, such as corporate ratings becoming more widespread Factors behind private bond market development

46. GRAs (established since 1909): - Apply a “standardized” rating methodology across countries regardless the environment in which firms operate NRAs (established since 1985): Have a comparative advantage to access more appropriate knowledge of local environment (Packer, 2000) Originated with the support of regulation (Kurosawa, 1999) Lower fees than those applied by GRAs (JCIF, 2001) Less independent, most of them are owned by financial institutions (Kurosawa, 1999) Main features of GRAs and NRAs

47. Market impact of GRAs and NRAs Specifically for Japanese financial markets: • combination of NRA and GRA ratings predicts spreads on securities’ secondary market trading more accurately than any of the two classes taken separately (Packer, 2000) • NRA ratings are more related to rated companies’ financial ratios than GRA ratings (Packer, 2000) • In the opinion of Japanese corporations, NRAs do not differ from GRAs in terms of market influence and recognition (JCIF, 2001) • Impact on abnormal returns larger for rating changes enacted by NRAs vis-à-vis those enacted by GRAs (Lacitignola, 2007)

48. Markets seem to take into account both NRA and GRA ratings when pricing securities (JCIF, 2001) By enlarging the number of rated companies, both GRAs and NRAs may actively CONTRIBUTE to FINANCIAL MARKET DEVELOPMENT

49. Only Asia features a significant presence of NRAs, elsewhere (e.g. EU) NRAs have been acquired by GRAs Figure 2 Source: Our calculations on Financial Times Interactive data for Winter 2004

50. NRAs issue numerous ratings compared to GRAs Figure 3 Source: Our calculations on Bloomberg data for 2004.