The Rise of Credit Rating Agencies

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Credit rating agencies (CRAs) have humble beginnings. The earliest rating guide was published in 1857 by the agency “John Broadstreet” and the private demand for third party corporate judges only rose as companies began issuing corporate bonds to fund their growth spree of the 19th century. As global markets evolved, with financial institutions taking centre stage, CRAs consolidated their role of risk mediators and their ratings have become indisputable evidence of an entity's creditworthiness. Their ratings provide investors with a quick snapshot of the creditworthiness and outlook of the security while corresponding reports go into more detail presenting possible risks and trends related to the stability of the issuing company/nation. These ratings have become so mainstream that many institutions and asset managers have regulations in place prohibiting the purchase of securities with a rating below a certain threshold. For instance, Fidelity Investments, an asset management firm classifies bonds to be investment grade if they have a rating of BBB- (on the S&P and Fitch scale) or Baa3 (on Moody’s scale) or higher. It is therefore the duty of CRAs to provide market players with the most accurate and up to date assessments of financial instruments, without any form of bias. Unfortunately, this is not always the case.

 

Credit Ratings for Sale!

The biggest players in the industry, commonly known as “the big three” – Moody’s, Standard and Poor’s and Fitch, control 90% of the market while only 6 other firms scramble to control the remaining tenth of market share.  They are the first port of call for companies wanting ratings and outlook perspectives. The industry’s first problem lies within the business models of the agencies, where the profit-seeking objective challenges their roles as unbiased market intermediaries. Suppose a firm wants to receive a rating for their new corporate bond issuance They will approach a CRA requesting an investigation into their business, receiving an appropriate rating before paying a fee for this service. This may seem like a normal transaction for a financial service. However, when put into a more familiar context, such as a university student handing in a piece of work for marking, while paying the professor a “fee,” the conflict of interest becomes more evident. In simpler terms, payments coming directly from clients may incentivise agencies to become more lenient and issue more favourable ratings to the highest bidder. The conflict of interest becomes more apparent when we introduce market competition into the equation.

 

Competition in Conflict: How market rivalry distorts credit rating integrity

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The conflict of interest arises not from a lack of competition, but paradoxically, from the very presence of it. The European Central Bank published a paper where they investigated the impact of intensified competition on rating quality for mortgage-backed securities between 2007 and 2020. There, they uncovered that the presence of competition will promote rating inconsistencies. Their findings suggest that CRAs “not only consider underlying credit risk factors when assigning a credit rating to an RMBS (residential mortgage-backed security) but also use ratings to expand market share and revenue.” Higher competition in this market incentivises agencies to one-up each other by offering more enthusiastic assessments and ratings. In the paper, the ECB examined how Moody’s and Dominion Bond Rating Service (DBRS), a smaller player in the industry, react to intensified competition. Unsurprisingly, when faced with increased threat of competition from Moody’s, DBRS provided more optimistic ratings on average. Evidence for this trend was seen in both smaller, and more dominant CRAs. Furthermore, the paper found that rating agencies are more likely to inflate ratings for a client with a higher market capitalization, further suggesting their interest in increasing and maintaining high client fees. Once again, the profit-seeking incentive and the fight for market dominance is what distorts the fairness and objectivity of credit risk assessments.

 

Silicon Valley Bank

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Besides conflict of interest or competition, credit rating agencies can make mistakes in their assessments, whether they are inaccuracies generated from simplistic methodologies, or oversights of unforeseen risks that have affected market conditions and hence the creditworthiness of firms. When all flaws are combined, a sense of disconnect between markets and credit ratings arises. Take the preceding events to the crash of Silicon Valley Bank (SVB) as an example.

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Between 2020 and 2021, SVB, a regional US bank, invested $91 billion of their cash stockpile into US treasuries and government agency mortgage-backed securities, having done so with the intent of holding the low-return assets until maturity. The bank did not hedge their bond portfolio against the looming threat of rising interest rates and would eventually pay the price.

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On March 8th, SVB disclosed a significant drop in its bond portfolio value, now at only $21 billion. The losses came due to a tightening interest-rate environment, causing the value of its bonds and mortgage-backed securities to nosedive. In a desperate attempt to avert panic, they planned to secure a $15 billion loan and urgently sell stock to raise an additional $2.25 billion. Unfortunately for the bank, investors and depositors of the bank were not convinced leading to a bank run where depositors rushed to take their funds out while investors dumped the stock. SVB collapsed on the 10th of March, and officially filed for bankruptcy on the 17th of March.

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Remarkably, since 2020 and until just a few days before the bank run in March 2023, Moody’s maintained an A1 credit-risk rating for SVB. For reference, A1 in qualitative terms reflects an “upper-medium-grade security, subject to low credit risk”. Only on the 8th of March 2023, just nine days before SVB filed for bankruptcy, was there a downgrade. The downgrade brought the rating to Baa1, representing a “medium grade” yet still qualifying it as investment grade for most institutional funds. Following the timeline, on the 10th of March, ratings were dropped lower to C and subsequently withdrawn following the bankruptcy of the bank. At that point, the rating downgrades didn’t come as a surprise to anyone, since by then, market panic was in full swing. This begs the question, why did Moody’s not revise SVB’s ratings sooner? Moody’s agency even conducted two periodic reviews of the bank in 2021 and 2022 with all the information regarding SVB’s bond holdings and worsening liquidity situation. They simply ignored or completely missed the red flags and kept rating unchanged. Ultimately, this left investors and depositors of the bank blind, magnifying the shock and panic that proceeded in the markets.

 

Regulations

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Regulators are not blind to these issues and are actively implementing new rules to solve them. In the latest set of regulations for credit rating agencies, The European Commission suggested reducing the overreliance of businesses on the judgements of CRAs and requiring financial institutions to strengthen their own procedures for credit risk analysis. By extension, this means removing any rating requirements for an ‘investment grade security’, instead to put trust into their in-house risk assessment divisions. This legislation is difficult to implement and enforce and may force companies to direct more capital towards risk analysis, increasing costs. However, it ensures that complacency towards risk is reduced, and investors are not left blind to a crisis emerging from just around the corner.

 

Final verdict: The double-edged sword of credit rating agencies

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To wrap up, this article has predominantly spoken negatively of credit rating agencies, only partially painting the complete picture. The simplification of risk analysis has made global markets more efficient and the easy to interpret ratings have helped categorize securities based on the reliability of the underlying firm. Credit rating agencies have themselves taken steps to improve their services by requesting more confidential information from clients to make more informed decisions. They are also providing more clarity and insights into their rating assessment processes through the extensive reports that are published alongside the ratings. But as with all things, they have their shortcomings. Regardless of whether it is due to a lack of information and resources or dishonourable intentions, it’s always best to do your own homework.