Start-up rating agencies urge national regulators to promote competition, change

August 15, 2011

By Rachel Wolcott

Aug. 15  (Thomson Reuters Accelus) –  Even as national governments cry foul over recent sovereign ratings downgrades, new rules and regulation aimed at rating agencies is making it harder for newcomers to break into the ratings market. Standard & Poor’s (S&P), Moody’s Investors Service and Fitch Ratings may have come under renewed fire because of the sovereign debt crisis, but rules set out in the United States’ 2006 Credit Rating Agency Reform Act and the Dodd-Frank Act have yet to open up the market as hoped.

The European Union, via the European Securities and Markets Authority, has also taken steps to clamp down on ratings agencies, but there again the ratings oligopoly remains largely unchallenged. Now, new entrants to the ratings market are urging regulators and legislators on both sides of the Atlantic to focus their efforts on promoting competition in the sector.


In July, witnesses before the Oversight and Investigations Subcommittee of the House Financial Services Committee reported that the cost of compliance and some transparency requirements make the cost of launching a new rating agency prohibitive. In addition, some potential contenders are reluctant to reveal details of proprietary technology and models for fear they will be copied.

Jules Kroll, executive chairman of Kroll Bond Ratings, told Thomson Reuters: “There have been no new entrants despite the entreaties to join the party. The reason is it’s not easy. We are making headway. We have won numerous assignments in the past few months, but we are well funded.”

In his testimony before the House subcommittee Kroll stated that the cost of compliance for any Nationally Recognized Statistical Ratings Organization (NRSRO) is a disincentive to entering the ratings business. He told the subcommittee Kroll Bond Ratings has spent more on compliance and legal costs in the past year than the revenue earned by its subscription-based service.

Kroll said: “We are mice trying to run with elephants. The ‘Big Three’ have very different structures. They have huge revenues and profits. The deck is stacked in their favour, because of the need to use — almost by name — these ratings agencies is embedded in loan documents, in regulations, they’re embedded everywhere.”

Testimony from S&P’s president, Deven Sharma, and Moody’s global managing director, Michael Rowan, underscored the incumbent agencies’ achievements in improving transparency and signalled their desire to see more competition in the ratings market. However, since January the ‘Big Three’ are reported to have spent more than $1 million lobbying Congress and federal agencies to effect change to proposed regulation that could put a dent in their market dominance.


The Securities and Exchange Commission has yet to be flooded with new NRSRO applications. Kroll’s agency launched last year with the purchase of LACE Financial, a subscription-based business specializing in rating financial services firms. Kroll has continued Lace’s legacy business and added a structured finance offering. Kroll said that he is seeking to expand the agency’s footprint beyond the US.

Meredith Whitney, the former Oppenheimer analyst credited with raising the alarm prior to the global financial crisis, is understood to be applying for NRSRO status through her firm Meredith Whitney Advisory. Another relative newcomer is Rapid Ratings, which is not an NRSRO. It uses a quantitative system to rate the financial health of corporate and financial institutions. Unless certain regulations with regard to transparency are changed Rapid Ratings is unlikely to become a NRSRO. It does not want to disclose the software behind its proprietary systems, which it believes gives it a unique edge over the ‘Big Three’.

James Gellert, CEO at Rapid Ratings, said in his subcommittee testimony: Until there are benefits that outweigh the costs, we’ll build our business outside the NRSRO framework.”

The only other movement in the U.S. ratings market has been Morningstar’s 2010 acquisition of RealPoint, a boutique NRSRO focused on the structured credit market, particularly commercial mortgage-backed securities.

In the subcommittee testimony, witnesses pointed to a few areas in existing and pending legislation which may have the unintended consequence reinforcing the hegemony of the ‘Big Three’. For example, there is the so-called 10 percent rule in the 2006 Reform Act. It states that no one client should represent revenue equal to or more than 10 percent of a NRSRO’s total annual revenue. For a smaller NRSRO, one client could easily put it over the 10 percent threshold. Kroll said that there should be exemptions for smaller firms.

“A $500,000 assignment is not unusual in the structured area. That is a flyspeck for the big agencies, because they are billion dollar entities, but for us, we’re just getting going. I’m hopeful that the government will recognize that these small company exemptions are important if they want to see genuine competition. We have no intent of remaining a small company, but you have to start somewhere,” he said.

On top of removing some of the barriers to entry, the smaller US competitors would like to see regulators promote competition through regulation. Regulators ought to remove regulatory requirements that issuers, banks and others must be rated by one or more of the ‘Big Three’. In his testimony, Kroll encouraged regulation that focused on the quality of rating agency output. Regulation should require the clear disclosure of accuracy of ratings to help investors see how responsive ratings are to changes in the markets, he argued.

Rapid Ratings’ Gellert testified that regulators needed to remove references from regulation that require the use of NRSRO ratings as well as promote innovation and limit the homogenization of ratings. Steps should also be taken to increase the flow of data needed to provide new ratings into the market.

Gellert also announced he would be writing to the U.S. SEC to suggest that all NRSROs would be required to file an affirmative statement confirming they had either confirmed or changed a rating on a quarterly basis. This initiative, he argued, would force firms to be more careful about their initial ratings and encourage them to stand by them.

His comments speak to the perception among critics of the ‘Big Three’ that they failed to conduct proper surveillance on structured credit deals and generally are slow to react to changing market conditions. Famously, the incumbent agencies maintained Lehman Brothers’ single-A rating up to a month before its bankruptcy. Their apparent rubber-stamping of structured credit deals with triple-A ratings is also blamed for contributing to the financial crisis.

More recently, S&P was forced to pull its ratings on two CMBS deals worth $2.7 billion. One $1.5 billion deal was being marketed by Citigroup and Goldman Sachs. Another worth $1.2 billion came from Freddie Mac. On the same day as the subcommittee hearing, S&P announced it found a problem in its model and withdrew its ratings, causing the deals to fail. Lack of investment in improving the models that they use is another criticism levied at the ratings agencies and critics say this latest incident shows little has changed.

Kroll said: “The day we testified I challenged the president of S&P and the global managing director of Moody’s to explain to me what’s changed. It looks to me like they are still operating in the same way. They say they’re much more transparent and they’ve been making changes. Then S&P issues this press release that says they’ve been issuing incorrect ratings based on their models at least since the beginning of the year. It’s unbelievable.”


In Europe there has been a similar lack of clamor of new entrants to the ratings market. The European Commission and ESMA (now responsible for regulating ratings agencies) have taken steps to increase the transparency of the ratings process and are seeking to eliminate conflicts of interest between the agencies and issuers. ESMA officials have stated that improving the quality of ratings is a crucial part of the greater project aimed at preventing a repeat of the last financial crisis.

By year end there will be 15 staff at ESMA devoted to ratings agencies, a considerable proportion of the regulator’s 72 total staff. ESMA will be examining the lack of competition in the ratings market, the conflict of interest in the issuer-pays model and potentially making agencies civilly liable for their ratings.

There is currently one German group seeking to establish a European ratings agency based in Frankfurt. Led by consultancy Roland Berger and supported by the Deutsche Börse, the federal state of Hesse and the Frankfurt Main Finance association, the aim is to create a ratings agency as a privately funded, non-profit foundation to address the dysfunctional elements in the established ratings market.

Markus Krall, the partner at Roland Berger in Düsseldorf heading up the ratings agency project, told Thomson Reuters: “There is a lack of competition. There is a conflict of interest. There is a lack of liability for the product that is a rating. A rating is effectively legally defined as an opinion. One is generally not paid for an opinion and we see it more as a product. These three elements are the constituents of what we see as dysfunctionalities of this market.”

To address these issues, Roland Berger and its partners are seeking to build an agency that is fully transparent in its methodology and models. It will use an investor-pays model, which it views as key to bringing some liability to the ratings business and tackling conflict-of-interest issues. It wants to create a central platform to collect information from issuers. That information could be accessed by any rating agency to perform a rating, which then would be published on the platform. Investors using a rating from the platform would pay for it.

As part of its efforts, Roland Berger and its partners are pushing for regulatory changes that will make its model feasible. One change will be to force issuers to disclose data. Another will be to force investors to buy a rating off the central platform or to perform a rating themselves, which might encourage investors to become independent of external ratings altogether.

Krall said: “It’s a broader kind of thinking we are applying here to change this market more fundamentally than just saying we are establishing another competitor. We are actively trying to convince the European Commission that our proposal to create an investor-based payment platform is the right way to sort out the market’s problems and to terminate the quasi-monopoly of today’s players. We are confident our arguments will be listened to and we see a good chance that the regulations to create such a platform will come into force.”

Roland Berger is working with Deutsche Börse and the federal state of Hesse to determine how it will set up the ratings agency and the central ratings platform. A project office is being created to coordinate that effort. Roland Berger also is in talks with a wide range of financial institutions — banks, insurance companies, fund and asset managers and exchanges — to garner support for its project. It is assembling a consortium of 30 or more founder investors to contribute a total of 300 million euros to fund the project.


While the nascent European Rating Agency is promoting the investor-pays business model, which Krall argues will eliminate conflicts of interest and create liability for the ratings product, historically there has been little success with this approach. Perhaps further regulation in the sector will compel investors to stump up for ratings, however in the past investors have bristled against such suggestions.

That the issuer-pays model contributed to unreliable ratings practices prior to the 2008 financial crisis is for some without doubt. In its report “Wall Street and the Financial Crisis: Anatomy of a Financial Collapse”, the US Senate’s permanent subcommittee on investigations’ committee on homeland security and government affairs pointed to rating agencies’ failings in the run up to the crisis. The report detailed how the incumbent agencies made huge profits rating structured credit deals. According to the report, in the frenzy to gain market share, agency analysts were pressured by their managers and issuers to rate deals favorably. Analysts who refused to play along were sidelined or, in some cases, dismissed.

The incumbent agencies’ desire for profit was found by the U.S. Senate report to be in conflict with their ability to provide an objective opinion. Much of the regulatory drive toward transparency is aimed at addressing this conflict of interest, however until the European Ratings Agency stated its plan to create an investor-pays model, it has been largely unchallenged.

Krall said: “The payment model is the root cause of the dysfunction we have seen. Without an investor-based payment system it won’t be possible to create liability for the product. Only if the investor pays will there be a contractual relationship between the agency and the investor.”

Jules Kroll investigated the possibility of an investor-pay model for Kroll Bond Ratings’ structured credit business and found it was a non-starter. “Investors don’t want to pay. We maintain the investor-pays model for our financial institutions business, which is a small, inherited business. The reality is I tried for nine months to put together a business model where the investors pay to eliminate the conflict of interest in terms of ratings shopping. The market is not buying. If Roland Berger can figure out a way for investors to pay I will happily join them,” he told Thomson Reuters.

Investors might not want to pay for ratings, but some do not necessarily reject the reasoning behind eliminating the issuer-pay model.

James Briggs, a credit portfolio manager at Henderson Global Investors in London, said: “I don’t think it would be a negative step to remove the relationship between the rating agency and the issuer. We are supportive of companies providing independent research, but not on a ratings basis. We’re not averse to paying for quality research from a firm that provides a good service. We support independent research where we think it adds value.”

What’s more some investors believe the way rating agencies operate and are compensated needs to change.

Briggs said: “There should have been more regulation and changes in the way the agencies function. One of the problems is they’re not rewarded based on accuracy of ratings. You could argue there’s no incentive for them to do a good job. I understand the need to separate the payment for services to keep them independent, but it would be nice if there were some incentive to provide a good service. In this instance that wouldn’t be a higher rating for the issuer but the accuracy of the rating.”


Rating agencies may be under pressure from regulators, but considering the role they played in the financial crisis the consensus is they got off lightly. Regulators could have shut down the rating agencies because of their systematic failure to rate structured credit products correctly. Considering the cost to taxpayers, some market commentators are incredulous that regulators have not taken more punitive measures against the ‘Big Three’.

Gary Jenkins, head of fixed-income research at Evolution Securities, said: “They are commercial organisations trying to maximize profitability and they have no financial downside risk themselves. From a financial point of view, they got all the cash, they didn’t get fined for it. They took a reputational hit, but that hasn’t affected their earning power. It’s a joke.”

Is making rating agencies liable for their ratings the answer? It may be the way regulators are going in Europe and indeed, Roland Berger’s Krall says that liability for ratings will be part of the European Rating Agency’s structure. Others, however, including Kroll of Kroll Bond Ratings cautions against this approach.

He said: “I’m not in favour of more liability by itself. I’m not anxious to walk around with a target on my back. People should be accountable for their work over time. When you’re looking into the future it’s hard. Rating agencies should be treated no differently than investment banks, consulting firms and investment firms. They should be accountable for their work. What’s happened today is that these firms have hidden behind the First Amendment saying ‘we’re journalists expressing an opinion’.”

Kroll said that rating agencies should be working to an agreed upon set of standards that spells out the ratings approach for the different areas of debt finance (bonds or structured finance, for example). Among these should be standards for the conduct of due diligence and surveillance. If rating agencies sign up to these standards then the question is whether they are carrying out their responsibilities in a way that complies with regulation.

Increased liability could also discourage new entrants to the ratings market and put off the establishment from rating riskier deals.

Nick Atkinson, a partner at PwC, warned: “I’m not sure having agencies take an increase in liability will lead to a greater depth of analysis or better analysis. It might lead to less willingness on the part of the agencies to produce detailed output which would be counterproductive. In the leveraged loan market, I see a great change in the willingness of agencies to privately rate transactions of a moderate size, perhaps partly because they perceive them to be at generally higher risk of default.”


Even if new market entrants are able to get their message across to regulators, the fact is the ‘Big Three’ have already invested a lot of time and effort maintaining the status quo. One reason their dominance is so tough to challenge is they’ve managed to convince regulators their business models don’t require substantive change.

Roland Berger’s Krall said: “It is a masterpiece of lobbying and public relations efforts to avoid a real crackdown on their business model.”

There are other assumptions among investors and other market participants that will go a long way to prop up the ‘Big Three’. There is a view that the rating agencies are so ingrained in the markets’ DNA that they’re impossible to remove. Another common argument warns that increased competition will result in a “race to the bottom” in ratings quality. New competitors point to the incumbents’ track record in structured finance before the crisis to dispel concerns about lower quality research.

Briggs, from Henderson, said: “We don’t feel there needs to be substantive change within the ratings industry. They’re addressing the issues and they’re doing it in a relatively transparent way. We wouldn’t say they have a fantastic track record and they did mis-rate a lot of structured products in 2006-07. With what they’re doing with sovereigns, we’d argue that they’re still behind the curve. They’re not downgrading countries quickly enough to catch up with debt-to-GDP, but they’re moving in the right direction. ”

Despite their faults, many believe the agencies serve a purpose. They bring consistency of approach to the ratings process. What needs to change, they argue, is how investors use ratings. Investors should only use ratings as part of their analysis, not as a proxy for proper credit work. Furthermore, investors should be better educated about what ratings are for and how they should be used.

Indeed, parts of the legislation coming out of the U.S. and the EU seek to encourage more independent credit work on the part of investors and financial institutions. The idea is to wean the financial markets off their dependence on the rating agencies and promote other ways of analysing credit risk. Many argue that is what good investors should have been doing all along. Deferring to agency reports instead of conducting a thorough analysis should have no place in responsible credit risk management.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete ( ions/regulatory-intelligence/compliance- complete/) provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)

No comments so far

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see