study report on credit rating agencies

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Credit Rating Agencies: An Alternative Model

Pragyan Deb and Gareth Murphy

November 2009

Abstract

We explore the conflict of interest which arises in the credit ratings industry due to thecurrent issuer-pay model. We argue that the most efficient way of aligning the incentives ofrating agencies is to return to an investor-pay system. Careful analysis of the reforms currentlybeing discussed suggests that, by themselves, they will have insufficient impact if the currentissuer-pay model is maintained.

While a return to the pre-1970s investor-pay model would solve the conflict of interestproblem, the issue of free-riding amongst some investors is likely to result in insufficient rev-enues for the rating agencies. We argue that although free-riding is a problem, the increasinguse of ratings by institutions coupled with the rise in the speed of information diffusion andpredominance of electronic trading venues over the last few decades would ensure that thereare investors willing to subscribe to ratings. This investor-pay revenue could be supplementedby a government subsidy to ensure that sufficient resources are available to the rating agencies.

To fund the government subsidy, we propose that a small tax would be levied on issuers

or at the point of issue. A limited number of rating licenses which provided a right to ratewhich would be auctioned (just like 3G auctions) and the auction winners would be entitledto a portion of the tax pool which is paid in arrears and linked to the share of the investor-paymarket that they manage to achieve.

Such a system would align the incentives of the rating agencies with investors, would ensurea commercially viable ratings agency industry and would have negligible impact on primaryissuance markets.

Keywords: Competition, Reputation, Financial Regulation, Auction, Industrial Organisation

JEL Classifications: C7, D4, G2, K2, L1, L9

London School of Economics and Financial Markets Group, E-mail: [email protected]

Bank of England, E-mail: [email protected]


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1 Introduction

The credit rating industry aims to offer investors valuable information about firms in need of

financing. Due to asymmetric information between the firms and the investors, credit ratings

often have a pivotal impact on the firms financing outcomes. However since the early 1970s,

rating agencies have relied on an issuer-pay model, creating a conflict of interest - the largest

source of income for the rating agencies are the fees paid by the very firms that the rating

agencies are supposed to impartially rate.1 This tempts rating agencies to rate better than what

fundamentals suggest, as many have pointed out during the recent subprime crisis.

In this paper, we explore the conflict of interest which arises in the credit rating industry due to

the issuer-pay model. The rest of this section reviews the current business model of rating agencies

and summarises the academic literature highlighting the problems with the current structure.

Section 2 examines the proposals currently being discussed to reform the rating agencies, and

suggests that by themselves, they will have an insufficient impact if the current issuer-pay model

is maintained. In Section 3, we propose an alternative structure for the industry - an investor-pay

model, supplemented by a government subsidy to ensure sufficient resources are available to the

rating agencies. Section 4 concludes.

1.1 Business Models: Past and Present

Before the 1970s, the ratings industry operated under an investor-pay model. Investors subscribed

to ratings released by the agencies, and these subscription revenues were the main source of income

for the rating agencies. However, owing to the public good nature of ratings and the increase in

free-riding due to the spread of the photocopier, rating agencies switched to the current issuer-pay

model.

In 1970s Moodys and Fitch switched to the issuer pay model with S&P following a few years

later2. As the market stands today, S&P and Moodys (which account for around 80% of the

market) rate and make public all SEC-registered firms, whether the rating is requested or not 3. Ifthe issuer does not request a rating, the rating agency issues a rating based on publicly available

information. If issuer requests a rating, it pays the rating fees and provides the rating agency

with private information about the firm. Typically an issuer gets a higher rating after having

solicited a rating from a rating agency.4

1SEC, 2008, p.92S&P switched to issuer pay model for municipal bonds in 19683FITCH only does solicited ratings4There are 2 possible explanations for this -

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The combined revenue from ratings of the big-three rating agencies - S&P, Moodys and

FITCH stood at US$3.7 billion in 2008. This, when compared with total rated bond issuance

of US$3.9 trillion5 implies average revenue from rating in the order of 10bps. This is important

for calibrating the subsidies in the investor-pay model outlined in section 3 since it suggests that

any tax imposed to fund the subsidy is likely to be small and thus have a potentially negligible

impact on the market.

Name Comments

Standard & Poors Ratings Services Largest playerMoodys Investors Service, Inc. Second largest after S&PFitch, Inc. Much smaller, but part of big-threeA.M. Best Company, Inc. Specialises in the insurance market

DBRS Ltd. Focus on CanadaEgan-Jones Rating Company Investor-payJapan Credit Rating Agency, Ltd. Focus on JapanLACE Financial Corp. Investor-pay, specialises in financial institutionsRating and Investment Information, Inc. Focus on JapanRealpoint LLC Specialises in structured finance market

Table 1: NRSRO designated rating agencies in US, as of September 2008

Apart from the big-three rating agencies, seven other rating agencies are recognised as Na-

tionally Recognized Statistical Rating Organizations (NRSROs) in the US. However, they are

comparatively tiny and they restrict their activities to particular market segments. An interest-

ing trend in the last few years has been the emergence of investor-pay rating agencies, such as

Egan-Jones Rating Company, LACE Financial and Rapid Ratings. Furthermore, as Firgure 1

shows, Moodys issuer-pay revenues fell from 89% of total revenues in 1999 to 72% in 2008. These

trends indicate that the investor-pay business model may be viable, although the issuer-pay model

is by far dominant and remains the main source of revenue for rating agencies.

1.2 Problems with the current system

The current issuer-pay system creates a conflict of interest for the rating agencies since their main

source of revenue, i.e the rating fee, comes from the issuers that the rating agencies are supposed

to impartially rate. An analysis of the annual reports of the big-three rating agencies suggests

that issuer-pay rating revenues account for roughly 84% of Moodys total revenues (average of

last 5 years), while the corresponding amount for S&P and FITCH is 72% and 85% respectively.

Sample selection bias - only firms with favorable information choose to solicit ratings.

Rating agencies are biased and improve the rating if they get fees.

5Both figures were down sharply due to the subprime crisis. In 2007, ratings revenues stood at US$4.9 billion,while bond issuance was US$4.7 trillion.

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86% 89% 86% 87% 83% 81% 80% 82% 83% 81% 72%

0

500

1000

1500

2000

2500

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

US$ million

Other Revenue

Ratings Revenue

Figure 1: Moodys ratings revenue (issuer-pay) has fallen over time

While rating agencies have long claimed that this conflict is unlikely to bias their ratings out of

concern for their reputation, the recent sub-prime crisis has clearly shown that this is not the

case.

Every rating agency has its own published fee structure, but there is widespread use of ne-

gotiated rates for frequent issuers. In general, frequent, large issuers tend to establish long term

relationships with the rating agencies, making the task of regulating the relationship much more

difficult. Thus, even if issuers are forced to pay rating agencies for initial analysis,6 it is unlikely

to ensure proper incentives for rating agencies when the issuer-rater relationship is viewed as a

long term relationship as opposed to a one-off transaction.Since the crisis, a growing body of research has highlighted the weaknesses of the current

model. Rochet, Mathis, and Mc Andrews (2008) show that reputational concerns are not enough

to solve the conflict of interest problem. In equilibrium, rating agencies are likely to behave laxly,

i.e. rate bad projects as good and are prone to reputation cycles. While Rochet, Mathis, and

Mc Andrews (2008) look at the conflict in the context of a monopolistic rating agency, Camanho,

Deb, and Liu (2009) show that the often sighted solution of introducing more competition is likely

6as proposed under the Cuomo Plan

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to aggravate the conflict further and lead to increased ratings inflation.

This result stems from the fact that increasing the number of rating agencies with the aim of

increasing competition, reduces an individual rating agencies reward from maintaining reputation.

If the overall size of the ratings market remains the same, then with increased competition, each

rating agency has a smaller share of the market. In such a situation, the benefits of maintaining

reputation (and giving honest ratings) falls and ratings inflation increases. Camanho, Deb, and

Liu (2009) show that in general, moving from a monopolistic to a duopolistic setting will increase

ratings inflation and aggravate the lax behaviour of rating agencies. Becker and Milbourn (2008)

measure empirically the relationship between competition amongst rating agencies on reputation

building. They show that increased competition7 leads to ratings inflation and less informative

ratings. Thus, reputational concerns are not sufficient to discipline rating agencies.

It is the case that this result depends critically on the assumption that the overall market

size remains the same. However, increasing the size of the ratings market by requiring issuers to

approach multiple rating agencies is also not likely to help. Bolton, Freixas, and Shapiro (2009)

show that with multiple ratings, issuers have more opportunity to rate-shop8 and in the presence

of naive investors,9 monopoly is superior to duopoly in terms of total ex-ante investor welfare.

Therefore, in order to enhance competition, if we allow for a large number of rating agencies,

more and more investors will find it difficult to infer rate-shopping and effectively the fraction

of naive investors in the market would rise. At the same time, with more rating agencies, theissuers ability to rate shop would increase thereby decreasing ex-ante investor welfare. Skreta

and Veldkamp (2008) do not consider the strategic behavior of rating agencies but explore the

interaction between rate-shopping, complexity of the security10 and competition. They show that

the intensity for rate-shopping increases with the complexity of the security and competition

between rating agencies amplifies this problem.

Both these papers argue for a ban on rate-shopping. However, such a ban11 coupled with

enhanced competition in the form of larger number of rating agencies will decrease the market

size for each rating agency, make existing clients more valuable and thus reduce their incentive

to maintain their reputation. Therefore, increasing the number of players while banning rate-

shopping is likely to aggravate ratings inflation as highlighted in Camanho, Deb, and Liu (2009).

7in the form of increased market share for FITCH8get multiple ratings from different rating agencies and make public only favourable ratings9investors who are unable to infer the extent of rate-shopping.10a key factor for structured products11which will be very difficult to enforce given the long term relationship between the issuer and the rating agency

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2 Proposed Reforms

There exists general consensus in policy circles on the need to strengthen the regulation of credit

rating agencies, including measures to promote robust policies and procedures that manage and

disclose conflicts of interest, differentiate between structured and other products, and otherwise

strengthen the integrity of the ratings process.12

However most of the reforms currently being discussed attempt to increase regulatory oversight

and disclosure norms in order to tweak the current issuer-pay system and make it more transparent

without attempting to eliminate the inherent conflict of interest outlined above. In what follows,

we look at some of the major reform proposals and argue that, by themselves they will have an

insufficient impact. However, when combined with an investor-pay model (as proposed in Section

3), they are likely to be highly effective in enhancing transparency and efficiency in the ratings

industry.

We look at the following reforms proposals -

1. Lowering Barriers to Entry

2. Holding Rating Agencies Legally Liable for their Ratings

3. Taxpayer Funded Credit Rating Agency

4. Ban on Rate-Shopping and Consulting Services

5. Make Ratings more Informative

2.1 Lowering Barriers to Entry

Moodys and S&P have dominated the credit ratings industry for years and together with FITCH

control around 95% of the market. The ratings industry has large and often prohibitive barriers to

entry. While some of these barriers such as reputation, scale economies and network effects13 are

inherent in the business, others are a result of regulatory restrictions and insufficient disclosure

requirements.

It has been suggested that if information is made more widely available, it might reduce entry

barriers to this industry, increase competition and serve to alleviate the incentive problems in this

industry. Typically, in the case of solicited ratings, issuers provide private information to rating

12US Department of the Treasury - Financial Regulatory Reform: A New Foundation (2009)13investors desire for consistency of rating categories across issuers limits number of players

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agencies. If this information is revealed to the wider market, then it could incentivise other players

such as insurance, pension and mutual funds, brokerages etc. to use this information in their own

internal reports and investment decisions. They can then act as investor-raters making their

reports public, providing the wider investor community with an additional source of information

- a de-facto rating . This will enhance the level of competition in the ratings industry.

However, as noted earlier, merely increasing competition in the ratings business is likely to be

counterproductive. However, in this case, since the funds and brokerages undertaking research

have a stake in their own ratings, they will not have the same conflict of interest that plague

the rating agencies. In essence, it will be similar to having incumbent rating agencies have a

stake (legal or economic) in their ratings. However, the potential for market manipulation by the

investor-raters needs to be taken into account. For example, investor-raters may be tempted to

sell their stake just before a downgrade or issue biased ratings in order to move the markets in a

particular direction.

At this stage, a distinction needs to be drawn between brokerages, which are likely to have

much wider coverage but less stake in their reports14 and mutual funds which would be much

more selective on their coverage, but are likely to have a much larger stake in their reports.15 In

general, wider coverage would mean having a lower stake in their reports. Thus, if the investor-

raters indeed morph into de-facto rating agencies and cover most asset classes, their stake in their

reports would become marginal and they will end up with incentives very similar to the incumbentrating agencies.

Even if these issues are resolved, we have another potential problem. Issuers may not be willing

to make their private information public. While they may be willing to disclose the information

to a rating agency in confidence, they may undermine their competitive position if the same

information is made available to the public and thus their competitors.

Thus we might get 2 different cases. In the first case, if disclosure norms are not mandatory,

then pure rating agencies will have access to additional private information provided by the issuers

vis-a-vis investor-raters. Thus investors have to decide between 2 different kinds of rating agencies

Pure Rating Agencies, that face a conflict of interest and potentially issue biased ratings,

but have access to private information of the issuers.

Investor-Raters, that face the right incentives, but are informationally constrained.

14which is primarily used as a marketing product15assuming their investment decisions are verifiably based on these reports

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Thus, this kind of a mechanism will be of limited benefit and will make the job of the investors

much more difficult.

The other alternative is mandatory disclosure of all private information. However, such a

policy may not be in the interest of the issuers. In the case of corporate issuers, it risks exposing

their company secrets to competitors. In the case of structured products, complete disclosure

would result in lower profits and thus decrease the incentive to innovate. The gains from financial

innovation will be capped because full disclosure will allow competitors to copy the product very

quickly. Over time, this may stifle innovation and may have detrimental welfare consequences.

Furthermore, such blanket disclosure requirements will be very hard to implement and are

likely to create inefficient market structures. For example, if disclosure requirements are imposedon one part of the market (for example on exchange traded products), then it would encourage

issuers to go for privately placed OTC instruments. Over time, the OTC market will expand and

end up becoming the dominant part of the system.

2.2 Holding Rating Agencies Legally Liable for their Ratings

Currently, credit ratings are treated as opinions and thus rating agencies cannot be held legally

liable for their ratings which are protected under free speech. However, if rating agencies are

made liable for the quality of their ratings,16 it would go a long way in resolving the conflict ofinterest. Currently, the only factor restraining rating agencies is the concern for reputation, but

if this channel is strengthened by forcing rating agencies to have a legal or financial stake in their

ratings, rating agencies would no longer find it profitable to inflate ratings. This would have the

same effect as having investor-raters in the market (see section 2.1)

However, given the nature of the ratings industry, it would be very difficult to force rating

agencies to have a stake in their ratings. Given the capital structure of rating agencies and the

size of the market that needs to be rated, a financial stake in their ratings is not feasible. 17 While

a financial or a legal penalty is possible in the event of ex-post poor quality rating, it would be

very hard to implement.

For the system of penalties for poor ratings to work effectively, it would require authorities

(regulatory or judicial) to be able to distinguish between poor ratings arising out of rating agency

bias or bad luck. If it is the former, then a penalty would be warranted, but in case of the latter,

the penalty would lead to inefficiencies.

16like auditors17unlike banks and other financial institutions, rating agencies do not hold any capital. Hence the US proposal

for joint lability

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It is very unlikely that authorities would be able to make such a distinction with relative

certainty, making a blanket penalty the only feasible option. But a blanket penalty every time

the quality of ratings falls below a threshold would do little to solve the incentive problem of

rating agencies.

Such a blanket penalty would only serve to make rating agencies excessively conservative.

This is because rating agencies, fearing the penalty would prefer to err on the side of caution and

give lower ratings. Therefore such a proposal would essentially replace the upward bias in ratings

with a conservative bias, leading to less informative ratings and possible capital misallocation.

Furthermore, the US joint liability proposal18 would make the entry barriers to the industry

even more prohibitive. This is because under such a system, any new potential entrant maybecome liable for all ratings issued by other players. As James H. Gellert of Rapid Ratings

International, Inc. puts it,19

Why would one want to become an NRSRO joining a group dominated by three players with

an iceberg of lawsuits looming on their horizon? That would be like swimming towards the

Titanic.

2.3 Taxpayer Funded Credit Rating Agency

A taxpayer funded rating agency would not be driven by commercial motives and thus such an

agency is not likely inflate ratings. Since investors are rational, they will take this into account

and thus the taxpayer funded agency will have perfect reputation.

If the taxpayer funded agency is just as efficient as the private rating agency, it will capture

the entire market. This is because given its perfect reputation and same cost to the issuer as

private rating agency, an issuer with a good project will always prefer to approach the taxpayer

funded rating agency for rating. The only case where an issuer will approach the private rating

agency is when it had a bad project and hopes that the private rating agency will give it a good

rating. But this will be fully anticipated by the market and the private rating agencies rating will

be useless. Thus in this situation, the presence of the taxpayer funded rating agency will lead to

the elimination of private rating agencies from the market.

On the other had, the taxpayer funded rating agency might have a perfect reputation, but it

may be less efficient in identifying good and bad projects. Thus for the investors, the trade-off

18See EuroWeek (2009) and Financial Times (2009b) for details of the US proposals to make rating agenciesjointly liable for their ratings

19See Gellert (2009)

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between private and public rating agency would boil down to a choice between between incentives

and ability. While the taxpayer funded rating agency will give unbiased ratings, it would be less

efficient. On the other hand, the private rating agency would give biased ratings but will be more

efficient at identifying projects.

This system by itself, will not solve the conflict of interest of the private rating agencies.

However, it might have a limited disciplining effect on private rating agencies by setting an upper

limit for ratings inflation. This is because the presence of a taxpayer funded rating agency may set

a lower bound for reputation of the private rating agency. If the reputation of the private rating

agency falls below the threshold, all issuers may approach the taxpayer funded rating agency

(same mechanism as above) and the private rating agency may be eliminated from the market.

2.4 Ban Rate-Shopping and Consulting Services

Rate-shopping refers to issuers approaching multiple rating agencies for rating and selectively

disclosing only those ratings that are favorable. Often issuers play one rating agency against the

other in order to get favourable ratings. To quote former chief of Moodys, Tom McGuire,20

The banks pay only if [the ratings agency] delivers the desired rating.. . If Moodys and a

client bank dont see eye-to-eye, the bank can either tweak the numbers or try its luck with a

competitor. . .

Furthermore, rating agencies routinely provide creative suggestions to issuers regarding the

design of structured products in order to improve ratings. The recent subprime crisis, provides

clear evidence of this. Instead of being neutral players, rating agencies were working actively

with investment banks on the design of complex securities, such as CDOs and MBS. As a former

Moodys expert in securitization says -

Every agency has a model available to bankers that allows them to run the numbers until they

get something they like and send it in for a rating.

Or, as Chris Flanagan, the subprime analyst at JPMorgan claimed

Gaming is the whole thing. . . Banks were gaming the ratings and designing only the securities

that were blessed by the rating agency.

20New York Times Magazine, Triple-A-Failure, April 27, 2008

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This is of particular concern for complex structured products since small superficial changes

to the asset pool or the nature of the contract can have disproportionate effects on ratings.

Thus, such consultations can potentially amount to data mining,21 severely underling the ratings

methodology.

Given this situation, it has been suggested that requiring rating agencies to disclose all ratings

irrespective of the wishes of the issuers as well as forcing rating agencies to make public any initial

consultation they may have with issuers can put a stop to rate-shopping. However, under the

issuer-pay system, given the complex nature of interaction between the issuers and the rating

agencies, it would be very difficult to enforce such a regulation. As is clear form the opposition of

rating agencies to any such move,22 rating agencies are unlikely to actively cooperate in the imple-

mentation of such regulation. Thus, such a move would require constant regulatory supervision,

making enforcement costly and difficult.

Furthermore, as pointed out in Section 1.2, such a ban would decrease the overall size of the

ratings market (by reducing the incidence of multiple ratings), reducing rating agencies incentives

from maintaining reputation and thus resulting in more ratings inflation.23

2.5 More Informative Ratings

It has been argued that as it stands, ratings do not provide sufficient information to investorsto make informed decisions. The current system of rating buckets are too coarse and provide

insufficient information to investors. The ratings bucket of different rating agencies have different

meanings and they often hide important details such as variance, likelihood of default and/or loss

severity in the event of default. This is particularly true in case of structured products which are

extremely complex and investors need more information to make informed decisions.

For example, under the probability of default based ratings approach (employed by S&P

and FITCH) the rating agency calculates the likelihood of income stream of a CDO tranche

falling short of its contractual value and determines the rating by comparing this likelihood with

historically calculated default probability. Similarly, under the expected loss based approach used

by Moodys, percentage expected losses are calculated and compared with historical benchmark

information. Both models provide an overall expected rating, but hide details regarding the

distribution of losses etc. which are vital for informed investor decision.

21Since every statistical model has some Type II error, i.e. failure to reject a null (high rating) when it is false,the issuer can get the desired rating by repeatedly tweaking the product. Thus through consultations, issuers canensure that their products get a hight rating, even if it is not warranted

22See Watson (2008a) and Watson (2008b)23See Camanho, Deb, and Liu (2009)

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While increasing the information content of ratings is a step in the right direction, the effect

of such a move on ratings bias is uncertain. Under the issuer-pay model, rating agencies will

find it optimal to inflate ratings, even if the content of the rating is more informative. However,

it is possible that more information will make it easier for investors to detect the bias and thus

make it a little less pronounced. But fundamentally, making rating more effective is unlikely

to solve the incentive problems of the issuer-pay model. However, as explained in the following

section, making ratings more informative while switching to the alternative investor-pay model

can mitigate the free rider problem to a large extent.

ProposalIncentive Commercially Rate- Direction of

Aligned Viable Shopping Rating Bias

Current System No Yes Yes InflationLower Barriers to Entry No Yes Yes

Inflation, potentialmarket manipulation

Holding Rating Agencies LegallyLiable for their Ratings

No No Yes Conservative

Taxpayer Funded Credit RatingAgency

Yes Yesa, Nob Yes Inflation

Ban Rate-Shopping & ConsultingServices

No Yes No Inflation

More Informative Ratings No Yes Yes InflationInvestor-Pay Yes No No None

Investor-Pay with subsidy Yes Yes No None

aif taxpayer funded rating agency is less efficientbassume taxpayer-funded rating agency is equally efficient

Table 2: Impact of Proposed Reforms

3 An Alternative Model

The analysis in section 2 suggests that the reforms currently being discussed will be insufficient to

solve the incentive problems inherent in the issuer-pay model. Thus we propose a return to the pre-

1970s investor-pay model. The investor-pay model is the most effective way of aligning incentivesof rating agencies and investors and eliminating the conflict of interest of rating agencies. However,

it is also prone to the problem of free-riding, resulting in insufficient resources for research and

analysis and thus poor quality ratings. As the rating agencies point out, free riding was one of

the main reasons behind the switch to an issuer-pay system in the 1970s.

While it is true that free riding is a big issue, the increasing use of ratings by institutions, cou-

pled with the sharp rise in the speed of information diffusion in the markets and the predominance

of electronic trading venues over the last few decades has increased the speed of price response to

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market events to only a few seconds.24 This is likely to ensure that there are investors willing to

subscribe to a rating agency as opposed to waiting for selected parts of the information to leak

through the market. The delay involved in free riding might be too costly for some investors.

Thus, investors that require ratings information quickly will be willing to pay in order to

avoid delays inherent in free riding. Investors such as large traders and brokerages, pension and

mutual funds, insurance companies and other institutions that have structures in place to act on

the information quickly will be willing to subscribe to the ratings as opposed to free riding and

waiting for the information to arrive with a lag. Given the high speed of information diffusion, the

opportunity cost of waiting is likely to be too high for such investors since the market would have

already moved in response to the ratings information. On the other hand, investors who cannot

trade immediately such as households and small retail investors, will have a low opportunity cost

and they would likely choose to free ride. However, in equilibrium, there would always be some

investors willing to subscribe to the ratings.

In this context, regulation aimed at making ratings more informative25 is extremely important

as it can potentially mitigate the free riding problem to a large extent. Even if investors are able

to learn the broad ratings bracket through free riding, it is unlikely that they will get access to the

necessary details fast enough if they try to free ride. They would need to subscribe to get reports,

access to analysts etc. Thus, as ratings become more and more informative, the opportunity cost

of free riding increases, mitigating the free rider problem to a large extent.

More formally, assume that investors using credit rating for their investment decisions can

choose to be subscribers or free riders. If they choose to be free riders, they do not have to pay

the rating agencies subscription fee (s). However free riding involves a delay and we assume that

the the opportunity cost of free riding for the investor concerned is .

As a modeling device, we assume that there exists a continuum of investors with lying

between a and b. Assuming a continuum of investors makes the model tractable26. Intuitively,

a represents the opportunity cost for a investor who would not act on the ratings information

(and is thus close to 0) while b is the highest possible opportunity cost (representing institutionalinvestors who would trade on rating information immediately).

Thus, each investor decides whether to free ride or subscribe depending on . If > s, then

the investor is better off subscribing to the rating agency as the opportunity cost of free riding is

too high. On the other hand, if < s, the investor prefers to free ride and wait for the information

24[[[[[quote papers on effect of media on speed of information diffusion]]]]]25See section 2.526The result holds for any possible distributional assumptions

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a b

SubscribersFree Ri ers

s

Figure 2: Investor Choice - Free Rider or Subscriber

to arrive with a lag. The fraction of investors subscribing to the rating agency is given by = bsba

.

Note that the fraction of subscribers is a function of the fees charged by the rating agency

and the information content of ratings. As the information content of the ratings increases (i.e. increases), the fraction of subscribing investors rises, thus mitigating the free rider problem.

Also, as the subscription fee falls, the the fraction of subscribing investors rises.

Therefore it is likely that there will always be a fraction of investors () who find it profitable

to subscribe to the rating agencies reports. Assuming a unit mass of investors and a per-subscriber

costs of rating c, the profits of the rating agency takes the following form:

= s c

The problem arises when the fee charged is relatively modest and/or the fraction is small.

In this case the investor-pay system may not generate enough revenues for the rating agencies,

i.e. < 0. In such a situation, the rating agencies will not survive or will be forced to cut costs

and compromise on the quality of their research. To avoid this scenario, it might be necessary to

establish a supplementary source of revenue for the rating agencies.

Such an alternate source of revenue can take the form of a government subsidy. In order

to provide rating agencies with the correct incentives, the subsidy should be proportional to

its subscription revenues. Such a subsidy will incentivise the rating agencies to maximise their

investor-pay revenues, thus aligning incentives. The new profit function becomes

= s c + s

An attractive feature of this structure is that it does not require costly regulatory information

as once the level of subsidy is optimally determined, the distribution of the subsidy amongst the

rating agencies is based on their respective market shares. This market determined distribution

system is much more desirable than the regulator trying to determine the share of each rating

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agency on a case by case basis.

This system is dynamic in the sense that it reflects the markets (investors) best guess about

the relative usefulness of different rating agencies ratings. If a particular rating agency does not

perform up to standards, its market share is likely to fall over time, and with it the subsidy. Thus,

this system provides a market determined measure of performance as opposed to a pre-set metric

which can result in regulatory arbitrage and is open to abuse.

Another big advantage of this system is that it makes rate-shopping much more difficult for

issuers. This is because with an investor-pay system, it is not in the interest of rating agencies

to hide (or not make public) an unfavorable report. Thus, with an investor-pay system, any ban

on rate-shopping will be much easier to implement since rating agencies would themselves have astrong incentive to comply with it.

A potential problem with the above system is that the rating agencies incentives will be

aligned only with fraction of the investors that subscribe to their ratings. If the incentives

of the remaining (1 ) free-riding investors are different, then it might result in a conflict of

interest27. This is particularly true if the differences in incentives are unknown or change in an

unpredictable way, then it might turn out to be a potential problem.

While we address this issue further in section 3.3, at this stage its important to point out

that making credit ratings more informative should mitigate this to a large extent (see section2.5). This is because, even if the incentives of the subscribing and free riding investors are not

perfectly aligned, they are unlikely to be in direct conflict with each other. They might have

slightly different preferences, but it is unlikely that they can gain at each others expense - as in

the case of issuers vs investors where there is a clear and direct conflict 28.

Furthermore, under this system, the capital structure and revenue stream of the rating agencies

are clear and open to scrutiny. Thus, if it would be easy to determine if a particular rating agency

is under the influence of a special interest group. As discussed in section 3.3, other rating agencies,

competing directly for market share, would do all they can to highlight this fact in order to win

over subscribers. Finally, a potent safety feature of this system is that the free-riding subscriberswould always have an option to subscribe to the ratings, thus aligning incentives limiting the

potential damage from misaligned incentives.

27For example, pension funds with a mandate to invest in only AAA securities might want more securities to berated AAA

28For example, a pension fund demanding AAA rated bonds, would still prefer bonds of a higher quality. Theymay prefer the rating brackets to be broadened to increase their scope and scale of operations, but they would stillprefer to invest in bonds that do not default

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3.1 Optimal Subsidy

From the regulatory perspective, determining the actual level of subsidy is not a trivial matter.

Given the revenue stream of the rating agency, the subsidy should be such that the rating agency

at least breaks even. Note that the break-even condition allows the rating agencies to make rea-

sonable profits in order to be viable and able to respond and invest to dynamic market conditions.

We set profits to 0 to simplify the exposition:

= s c + s = 0

or =c

s 1

In order to optimally determine , the regulator needs detailed and accurate information on the

rating agencys costs as well as demand, supply and optimal pricing of the ratings. While this is

possible (as in the case of other regulated industries like electricity, gas, water etc.), this is likely

to impose a heavy burden on the regulator. Furthermore, ever if the regulator could optimally

set , since the subsidy is designed to ensure that the rating agencies break even in equilibrium,

it would deter rating agencies from competing for market share.

Given this problem, we need a mechanism which imposes less informational burden on the

regulator and preserves the incentives of the rating agencies to compete amongst themselves for

investor-pay revenues and market share. In order to ensure the latter, the subsidy should be fixed

a-priori allowing rating agencies to maximise their profit without worrying about an offsetting

reduction in the subsidy. Thus the rating agency should reap the rewards from ex-post increase in

market share arising from improvement in the ratings and overall quality of service, innovation,

cost reduction etc.

Since each rating agency is best suited to determine its own cost structure and expected

revenues, we propose an auction mechanism, similar to the 3G auctions, to determine the

optimal subsidy rate for the rating agencies. Each rating agency determines the minimum level

of subsidy it requires to break even

i =ci

isi 1

If the auction process is properly designed, then the most efficient rating agencies, i.e. the ones

that are confident of getting higher subscription revenues from the investors and have lower costs

will win the auction. After the auction, the rating agencies will continue to compete since the

subsidy is contingent on the investor-pay revenues.

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The auction process would involve giving rating agencies the right to rate and get the subsidy

for a fixed number of years. The optimal period would depend on the length of time the rating

agencies require to recoup their costs and make reasonable profits. Thus, the period would be

a critical factor in determining the attractiveness of the auction process and thus the degree of

competition. For the sake of this exposition, we assume that 5 years is optimal.

Furthermore, in order to maintain the quality of ratings and make the ratings market more

dynamic, we propose repeat annual auctions on a rolling basis. In the annual actions, the rating

agency that has the lowest market share and has completed its guaranteed 5 year period will

have to compete in the auction once again for the right to rate. This will ensure that there

is enough competition in the market and incumbent rating agencies are forced to continuously

compete and maintain best possible rating standards. Thus this mechanism would use the market

to determine and punish the most inefficient rating agency as opposed to having the regulator

measure performance base on a particular metric.

3.2 The Auction Mechanism

A well designed auction is the method most likely to allocate resources to those who can use

them most valuably since it forces business to put their money where their mouths are when

they submit bids.An auction can therefore extract and use information otherwise unavailable tothe government.29 However, it is vital that the auction is properly designed and tailored to the

particular context. We look at the literature on 3G licence auction for motivation on optimal

auction design for the ratings business. Broadly, the optimal auction mechanism should achieve

3 main objectives:

It should allocate the right to rate to the most efficient rating agencies

It should promote competition

It should minimises the subsidy burden

One of the key challenges in designing the auction for the ratings industry is the big advantage

of incumbents30 over potential new entrants. As discussed earlier, the ratings industry is plagued

by barriers to entry, both economic and regulatory. In addition to the large set-up and fixed

costs to entry, incumbents also have the advantage of established customer bases and brand-name

29For example, the successful UK 3G auction yielded about 22.5 billion or 212

% of GNP and resulted in a com-petitive telecom market in the UK

30particularly the big 3 rating agencies - S&P, Moodys and FITCH

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recognition. Thus, in order to make the auction process competitive, it is vital that the auction

design provides sufficient incentives to new entrants.

One of the key parameters to achieve this is the number of licences. Since there are three

dominant incumbents in the market, the number of licences on offer should be greater than three.

Otherwise any new entrant would be deterred from participating in the auction process rendering

it inefficient.31 However, in the context of the ratings industry, given its current structure and

the barriers to entry that already exists, giving out more than three licences, coupled with the

fixed term guarantee to recoup costs, might actually lead to a decline in entry barriers and foster

competition.

The other potential problem with the auction mechanism is that the incumbent rating agenciesmight feel forced to win a new licence in order to avoid a sharp reduction the value of their

previous investments. The proposal to require the worst performing rating agency to participate

in the auction process after the fixed guaranteed term would lead to disruptions and can act as

a disincentive for rating agencies from participating in the auction. However, such a mechanism

is vital to ensure efficiency and continued competition in the ratings industry. The incumbents

disincentive from repeat auctions must be balanced with the need to maintain a dynamic system.32

While the exact length of time a rating agency needs to recoup costs is debatable, some kind of

penalty for poor performance is necessary to maintain market efficiency. In any case, after the

fixed term, the worst performing incumbent rating agency will still be allowed to compete inthe auction process. We believe that the risk of losing the right to rate is no different from

the general penalty for poor performance in the market. Risk is part of any business and rating

agencies are free to take this into account while competing in the bidding process. In principle,

the number of licenses can be changed to reflect the prevailing market conditions

Broadly, we have 3 distinct auction mechanisms:

Simultaneous Ascending Design

equivalent to Second Price Auction

Sealed Bid Auction

equivalent to First Price Auction

Hybrid Anglo-Dutch Design

31For example, the Netherland 3G auction of July 2000 performed poorly because there were 5 licences with 5incumbents, deterring potential new entrants

32Repeat auctions can be made contingent of the market share of the worst performing rating agency fallingbelow some pre-determined threshold. However, such a system risks cartelisation of the industry, with incumbentsnot competing with each other in order to sustain super-normal profits.

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combines element of both

We analyse these 3 types of auctions with a view to see which is best suited for the ratings

industry.

Simultaneous Ascending Design

In the simultaneous ascending auction, or the English Auction, participants bid openly against

one another, with each subsequent bid higher than the previous bid. The auction ends when no

participant is willing to bid further, at which point the highest bidder pays their bid. The

distinguishing feature of this auction type is that the current highest bid is always available to

potential bidders. Thus, in terms of outcomes, its equivalent to the sealed bid, second priceauction. In the context of allocating multiple, equivalent licences, the auction ends when the

number of participants remaining are equal to the number of licences available. Thus, the subsidy

is equal to the level required to sustain the least efficient rating agency.33

While this type of auction ensures that the most efficient rating agencies win the auction and

also the subsidy is kept at a minimum, it discourages competition and entry. In an ascending

auction, there is a strong presumption that the firm that values winning the most will be the

eventual winner, because even if it is outbid at an early stage, it can eventually top any opposition.

Thus, dominant incumbents with established structures and client base can outbid potential

entrants at any stage. This can create a situation where potential entrants are discouraged to

even participate in the bidding process even in the presence of modest bidding costs. This results

in insufficient competition during the auction and can result in high levels of subsidy due to

cartelisation of incumbents. Thus, in the presence of strong incumbents, this kind of auction

often leads to insufficient competition.

Sealed Bid Auction

In the sealed bid auction or more formally the first price sealed bid auction, all bidders simul-

taneously submit sealed bids so that no bidder knows the bid of any other participant. Bidders

make a single best and final offer. The highest bidder, in this case the rating agency requiring

the lowest subsidy, wins and the subsidy equals its own bid.

From the perspective of encouraging more entry, the merit of a sealed-bid auction is that

the outcome is much less certain than in an ascending auction. An advantaged incumbent will

probably win a sealed-bid auction, but it must make its single final offer in the face of uncertainty

about its rivals bids, and because it wants to get a bargain, its sealed-bid will not be the lowest

33with more efficient rating agencies making a profit

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subsidy it could be pushed to in an ascending auction. So weaker bidders have at least some

chance of victory, even when they would surely lose an ascending auction

Because sealed-bid auctions are more attractive to entrants, they may also discourage consortia

from forming. If the strong rating agencies form a consortium, they may simply attract others

into the bidding in the hope of beating the consortium. So incumbent rating agencies are more

likely to bid independently in a sealed-bid auction, making this auction much more competitive.

Thus the greatest advantage of this type of auction is that it gives weak bidders a chance (a

hope and dream in the words of one frustrated potential entrant) which can attract more bidders

and results in more competition in the bidding process. However, this very fact is also its greatest

shortcoming - because it allows bidders with lower valuations (higher costs in this context) tosometimes beat opponents with higher values (and so encourages entry) it is more likely to lead

to inefficient34 outcomes.

Furthermore, sealed bids do not allow bidders to gather information on the business plans

of their rivals by observing who is staying in and who is getting out as the price rises. They

therefore make it impossible for bidders to refine their valuations of the licences on the basis

of this information. Thus, this type of auction is only recommended when the most important

objective is to encourage potential bidders to entry.35

Hybrid Anglo-Dutch Design

The Anglo-Dutch design tries to marry the benefits of both type of auctions. In an Anglo-

Dutch auction for one object, the price rises until all but two bidders quit and the last two bidders

then make a sealed bids. With 5 licences to sell, the subsidy would fall until only 6 competitors

remained. The surviving bidders would then be committed to bid at or below this level of subsidy

in a sealed-bid auction in which the four lowest bidders are awarded a licence. There are two

versions of the Anglo-Dutch design; one in which each winner is committed to receiving its own

bid, and one in which each winner is committed to paying the fifth-highest winning bid. While the

former is more likely to encourage competition, the latter is more efficient in term of extracting

private information of bidder and incentivising rating agencies to reveal their costs truthfully.

The sealed-bid stage of the Anglo-Dutch design encourages competition by giving a chance

to weaker players. Just as in the standard sealed-bit auction, weaker bidders have a chance of

winning the auction and unlike the ascending price auction be outbid by the dominant incumbents.

This encourages entry into the auction. However, as noted above, this also leads to inefficiencies.

The Anglo-Dutch design tries to overcome this by having an ascending auction as the fist stage.

34rating agency with higher costs winning the auction process35As in the successful Danish 3G Auction of September 2001

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This ensures that the auction does not result in very high levels of subsidies because of under-

bidding by all players. However, by having a sealed-bid stage, it encourages weaker participants

to stay in the auction in the hope of winning in the last stage. Essentially, this design tries to

balance the twin goals of encouraging competition, while at the same time ensuring that there

is an efficient outcome, i.e a high cost rating agency does not win the auction and the subsidy

burden is minimised.

The table below summarises the features of the 3 types of auctions -

Auction Type Entry Efficiency

Simultaneous Ascending Design Lowest Highest

Sealed Bid Auction Highest Lowest

Hybrid Anglo-Dutch Design Moderate Moderate

Table 3: Comparision of different Auction Types

Given that the initial auction is likely to offer more licences than the number of incumbents,

we believe that the Anglo-Dutch design is most appropriate in this setting. It balances the twin

goals of encouraging entry while at the same time ensuring that the most efficient rating agencies

have a greater chance of winning, thus enhancing overall efficiency and keeping the subsidy burden

low. For the later annual auctions, we recommend the sealed bid auction. This is because in the

annual rounds, an incumbent and potential new entrants must compete for a single licence, with 4

other incumbents already part of the industry. In such a situation, more incentives are necessary

for new entrants and the sealed bid auction is most appropriate.

3.3 Industry after the Auction

After the auction, the industry would consist of a given number of rating agencies, competing with

each other for market share. The profits of an individual rating agency would depend critically on

its investor-pay revenues, since the subsidy from the government would be linked to this revenue,

thereby aligning the incentives of the rating agencies with the investors. A critical factor in

determining the attractiveness of this design is the nature of competition in the industry after

the auction and the mechanisms in place to prevent the rating agencies from coming under the

influence of a particular class of investors.

Insufficient competition and cartelisation can lead to moral hazard problems for the industry

leading to high cost and poor quality ratings. However, by its very design, the repeat auction

mechanism ensures competition. The threat of new entry is likely to force the rating agency

with the smallest market share to break the cartel and increase effort in order to gain gain market

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share. This would in turn induce all other rating agencies to exert effort as no rating agency would

want to risk competing in the auction and loose its right to rate. The more likely situation is

intense competition and a race to the bottom. If the rating agencies are homogenous, then this

is the likely outcome with each rating agency undercutting the other resulting in a Bertrand

Equilibrium with subscription fees close to 0. However, ratings are differentiated and we look at

the Industrial Organisation (IO) literature to outline the nature of competition and differentiation

in the ratings industry.

Rating agencies can differentiate each other across two dimensions - the quality of their ratings

and their coverage and specialisation. In the IO literature, the former is classified as Vertical

Differentiationwhile the latter is known as Horizontal Differentiation. Under both these settings,

rating agencies would make positive profits, have different market shares and would cater to

investors with different preferences.36

Vertical Differentiation refers to differentiation on the basis of the quality of ratings. Rating

agencies can choose to provide high quality rating and charge a higher price or they can provide

lower quality ratings for a lower price. Investors choose between the different rating agencies based

on their own preferences i.e quality vs price. The market share of a rating agency would ultimately

depend on the preferences of investors as well as the market segment the rating agency targets.

The IO literature suggest that in general, rating agencies would find it optimal to differentiatethemselves as opposed to competing directly with each other by catering to the same market.37

Horizontal Differentiation refers to specialisation in different products. In this setting, dif-

ferent rating agencies would choose to specialise in different financial instruments and regions.

For example, while one rating agency may specialise in corporate bonds the other may choose to

specialise in structured products. Investors would choose different rating agencies on the basis of

their individual preferences. Thus an investor primarily investing in corporate bonds would go for

the rating agency specialising in corporate bonds while an investor investing in structured prod-

ucts would subscribe to the rating agency specialising in it. Once again, the IO literature suggestrating agencies would choose to differentiate and cater to different segments of the market38

Thus the ratings market can be thought off as a two-dimensional space, with rating agencies

choosing where to position themselves in order to differentiate themselves from their rivals (see

36The current market structure shows some evidence of such differentiation, with the smaller rating agenciesspecialising in particular sectors or regions. See Table 1 for details.

37See Gabszewicz and Thisse (1979, 1980), Gabszewicz and Thisse (1980), Gabszewicz, Shaked, Sutton, andThisse (1981), Bonanno (1986) and Gal-Or (1983)

38See Hotelling (1929) and Salop (1979)

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figure 3). The vertical axis shows quality while the horizontal axis represents specialisation in

different products. Investors choose the rating agency based on their preference for specialisation

and quality. Since ratings are differentiated, the rating agencies have some market power and

make profits in equilibrium.

HorizontalSpecialisation in different products

Vertical

Differencesin

qualityo

fratings

Rating Agency

Figure 3: Market for Ratings - differentiated by quality and specialisation

Note that the distribution of investors in the two-dimensional space need not be uniform.

For example, the proportion of investors demanding very high quality, more expensive ratings

might be much higher than those demanding lower quality, cheaper ratings. The rating agency

targeting the high quality segment of the market will in general have a higher market share.

However, while such a position would be sought after by all rating agencies, once a particular

rating agency positions itself in this position, the other rating agencies would find it optimal to

cater to a different segment of the market. This is because rating agencies would prefer to relax

price competition through product differentiation.39

If it so happens that most of the clients of one particular rating agency belong to a particular

class (say pension funds), then some other rating agency would position itself to target a different

segment of the market. In so doing, they would continue to serve their may economic purpose

39see Shaked and Sutton (1982)

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- to facilitate collective research instead of each investor being forced to conduct research on a

individual basis.

The often sighed danger of investor-pay rating agencies coming under undue influence of

a particular class of investors can be minimises further by requiring rating agencies to make

public the distribution of their investor-pay revenues across the population of investors. Since

rating agencies would already be providing information on their total investor-pay revenues to

the regulators in order to get the subsidy, this should not impose undue burden on the rating

agencies. Such disclosers would make any possible ratings bias clear to the investors. In case the

market is unable to correct the potential biases, such data would also allow regulators to identify

any concentrations or deficits in the market and take corrective measures.

4 Conclusion

Since the credit-crisis, widespread concern has arisen about the functioning and business model

of rating agencies, both at an academic level as well as in policy circles. There exists general

consensus on the need to strengthen the regulation of rating agencies. However, the proposals

currently being discussed are insufficient to resolve the conflict of interest inherent in the issuer-pay

business model of rating agencies. As Branson Davies puts it,40

The rating agencies are so compromised that no amount of regulation can, in my view, make

up for the the fundamental flaws in their incentive structures which is simply a reflection of a

flawed business model.

We look at the proposals currently being discussed and reach a similar conclusion. As is clear

from Table 2, the proposed reforms, by themselves, will have an insufficient impact if the current

issuer-pay model is maintained.

However, drawing on various strands of the academic literature, we propose an alternative

model for the industry which:

Aligns the incentives of the rating agencies

Puts a stop to rate-shopping

Leads to unbiased ratings

Makes the ratings industry commercially viable

40see Davies (2008)

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Results in a market driven, competitive ratings industry

We propose a return to an investor-pay model supplemented by a subsidy from the government.

In order to keep the industry market-oriented and minimise the regulatory burden, we propose

an auction mechanism to provide the right to rate to the most efficient rating agencies. We

further propose repeat annual actions in order to provide a market-based stick to discipline the

rating agencies and ensure dynamism and competition in the industry. Furthermore, our model

addresses two key criticisms of the investor-pay solution to the ratings conundrum. It creates a

supplementary source of revenue for the rating agencies, mitigating the free riding problem. At

the same time, our model ensures that rating agencies are not unduly influenced by a particular

class of investors with their own agendas by forcing rating agencies to compete for investor-payrevenues by differentiating themselves and catering to all classes of investors.

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study report on credit rating agencies

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