Ratings agency business model under fire

The credit rating agencies’ failure to assign accurate ratings to mortgage securities inundating the US sub-prime market in 2008 is old news. What is new is the rising concern about their monopoly of the ­ratings market and their ever evolving ­business structures.

The latter makes it difficult for the outside world to keep track of where their interests lie and how their methodologies work.

Louis Pestel, senior analyst at French fund selector Insti7, says the real problem is that they change their methodologies too often.

“They are so involved with their business that even large institutions cannot follow every development and ­announcement. We don’t have time to read all of this information.”

To keep up, “you need to be totally involved,” he adds. A spokesperson for Standard & Poor’s agrees, ­admitting the agency has undergone so much restructuring lately it was “hard to keep up” with the changes internally, let alone externally.

This confusion in part stems from S&P, Moody’s and Fitch having grown their businesses substantially over the past decade: Moody’s now offers credit ratings and research as well as financial risk management and ­economic research.

S&P and Fitch provide credit, ­sovereign, fund and asset manager ratings. McGraw Hill, S&P’s parent company, also runs a profitable indices business. Yet ‘the Big Three’ deny adamantly their sprawling ­business models could be playing host to problems of objectivity.

The credit and fund/asset manager ratings carried out by the major ­agencies are implemented via an issuer pay model. This means issuers or fund managers pay an agency to rate its debt or fund.

The fee it charges depends on the complexity and volume of work involved and, with credit ratings, the volume of rated debt issued. A small fee may be charged as a percentage of the rated debt issuance, or large issuers might receive a bulk discount.

Critics are concerned this model encourages the agencies to assign better ratings to wealthier clients to win their long-term business. ­Alternatively, downgrading important clients could have knock-on effects on revenues – issuers could be encouraged to shop around looking for the most lenient rating provider.

 

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