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COMPETITION IN RATING
AGENCIES
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Credit ratings make informationabout default likelihoods andrecovery rates of a security
widely available, limiting duplicationof effort in financial markets. Theyallow uninformed
investors to quickly assess the broadrisk properties of tens of thousands ofindividual securities using a single and
well-known scale.
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The industry is dominated by onlythree players Moodys, Standard &Poors (S&P), and Fitch with Fitch
only gaining prominence in the pastdecade or so.
Ratings issued by agencies the
investors use them for free.
The Securities and ExchangeCommission (SEC) now recognizes
ten firms as Nationally Recognized
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Paul Schott Stevens, the President ofthe Investment Company Institute,stated I firmly believe that robust
competition for the credit
rating industry is the best way topromote the continued integrity and
reliability of their ratings.
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Founded in 1913 Fitch.
1989 when a new management team
recapitalized Fitch. This was followed by a merger in
1997 with IBCA Limited, which
specialized in coverage of financialinstitutions.
Fitchs continued growth from this
year forward was both organic andinor anic includin the ac uisitions
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Fitchs corporate ratings wascemented by the July 1, 2005inclusion into the Lehman (now
Barclays Capital) Index thatdifferentiates between investment-grade and junk (high-yield) bonds.
Prior to this change, Lehmanassigned the lower of Moodys orS&Ps rating to any corporate bond,
and thus in situations where one of
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we focus on two dimensions ofquality: the
ability of ratings to transmitinformation to investors and theirability to classify risk.
The basic intuition behind thisinterpretation of quality is as
follows:-
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ratings inflation may hurt theinformation
transmission of ratings if not allinvestors are sophisticated.
inflation will make regulation and
contracting with ratings more difficult(since these rely on stable meaningsof the categories).
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The evidence we uncover appearsunequivocally consistent with lowerratings quality as competition
increased. First, ratings issued byS&P and Moodys rose (moved closerto the top rating of AAA) as
competition increased. Second, theability of S&Ps and Moodys ratingsto explain bond yields decreasedwith competition. In other words,credit ratings are less informative
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speculative grade firms are 7.7times as likely to default within threeyears as investment grade firms
when competition is low (Fitchmarket share is at the 25thpercentile), but only 2.2 times as
likely when competition is high(market share at the 75th percentile).
individual bonds which are rated by
Fitch tend to have lower ratings from
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Another possibility is that Fitchmight find it easier to enter and growin industries where
S&P and Moodys neglect firms andtherefore produce uninformativeratings.
This story does not explain ourresults about
ratings levels, and leavesunex lained the basic issue of wh
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Fitchs ratings are more in demandwhen default is harder to predict,possibly owing to industry opacity or
rates of industrial change. why would ratings be higher when
default is difficult to predict?
Revenues and profits of raters grewquickly over the sample period. Forexample, from 1997 to 2007, roughly
corresponding to our sample period,
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Fitch does not appear to havegained a higher market share whenpredicting default was hard.
raters concern for their reputationsas providers of honest and accurateratings may help sustain ratings
quality. By providing accurateratings, they improve future business
opportunities.
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For a rating agency.. (S&P) claimedthat reputation is more importantthan revenues.
The reputational theories argue thatcompetition can threaten quality byreducing future rents, but it appearslikely that the massive expansion inthe ratings industry during our
sample period generated increases in
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If market size affects the payoff tohigh quality (more expected futurebusiness, as the firms reputation for
quality is maintained) and the payoffto low quality (more business orhigher fee revenue from bond
issuers) similarly, reputationalconcerns would appear unaffected bymarket size. If the market expansionis temporary, the incentives to cheatmay in fact be enhanced by market
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ratings inflation could be thephenomenon of
Ratings shopping that hascome to describe the process by whichissuers shop around for good ratingsand that ultimately the ratings we
observe are the ones that wereconsidered most positive by issuers.
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Skreta and Veldkamp show thatincreases in asset complexity (suchas mortgagebacked
securities and CDOs) leads to moreratings shopping and a systematic biasin disclosed
ratings.
As Spatt (2009) points out, ratingsshopping can only occur if thesecurit issuer ets to choose which
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Even if an issuer refuses to pay for arating, the raters publish it anywayas an unsolicited rating, and thereby
compromise any potential advantageof ratings shopping.
We find that S&Ps and Moodysbond ratings are slightly lower forbonds that have a Fitch rating
(controlling for observables). This is
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Bongaerts, Cremers, and Goetzmann
(2010) find that Fitch ratings tend to
be higher than those issued by S&P
and
Moodys, but reject this as evidence
of ratings shopping or two importantreasons. First, investors do not lower
credit
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We conclude that competition mostlikely weakens reputationalincentives for providing
quality in the ratings industry, andthereby undermines quality. Thereputational mechanism appears to
work best at modest levels ofcompetition.
There are a number of caveats and
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Our findings may shed light on someof the regulatory changes that havebeen contemplated and
implemented for the credit ratingsindustry, including increasedcompetition. . Further competition it
is not likely to improve quality. Ourfindings indicate that quality in theratings industry relies on rents thatreward reputation-building activitieswhich are costly in the short run. The
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competition might have othereffects, including reducingmonopolistic (or in the case of
ratings, oligopolistic) rents, andadding information to financialmarkets (since raters sometimes give
different ratings).
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