User:Mysidae/Industry structure

Industry structure

Further information: Big Three (credit rating agencies)

The three largest credit rating agencies—Standard & Poor's, Moody's Investor Service, and Fitch Ratings—are collectively referred to as the "Big Three" due to their substantial market share. According to the most recent U.S. Securities and Exchange Commission (SEC) report, the agencies together account for approximately 96% of all credit ratings. A 2011 report by Deutsche Welle reckons their "collective market share" at "roughly 95%".

As of December 2012, S&P is the largest of the three, with 1.2 million outstanding ratings and 1,416 analysts and supervisors. Moody's is the second largest agency, with 1 million outstanding ratings and 1,252 analysts and supervisors. Fitch is the smallest of the Big Three, with approximately 350,000 outstanding ratings, and is sometimes used as an alternative to S&P and Moody’s.

Since the establishment of the first agency in 1909, there have never been more than four credit rating agencies with significant market share. Why this concentrated market structure has developed is disputed. One widely cited opinion is that the Big Three's historical reputation within the financial industry creates a high barrier of entry for new entrants. Following the enactment of the Credit Rating Agency Reform Act of 2006, seven additional rating agencies have attained recognition from the SEC as Nationally Recognized Statistical Rating Organizations (NRSROs). While these other agencies remain niche players, some have gained market share following the 2008 financial crisis, and in October 2012 several announced plans to join together and create a new organization called the Universal Credit Rating Group. The European Union has considered setting up a state-supported EU-based agency.

The three largest agencies are not the only sources of credit information. Many smaller rating agencies also exist, mostly serving non-US markets. All of the large securities firms have internal fixed income analysts who offer information about the risk and volatility of securities to their clients. And specialized risk consultants working in a variety of fields offer credit models and default estimates.

Business models

Credit rating agencies generate revenue from a variety of activities related to the production and distribution of credit ratings. The sources of the revenue are generally the issuer of the securities or the investor. Most agencies operate under one or a combination of business models: the subscription model and the issuer-pays model. However, agencies may offer additional services using a combination of business models.

Under the subscription model, the credit rating agency does not make its ratings freely available to the market, so investors pay a subscription fee for access to ratings. This revenue provides the main source of agency income, although agencies may also provide other types of services. Under the issuer-pays model, agencies charge issuers a fee for providing credit rating assessments. This revenue stream allows issuer-pays credit rating agencies to make their ratings freely available to the broader market, especially via the Internet.

The subscription approach was the prevailing business model until the early 1970s, when Moody's, Fitch, and finally Standard & Poor's adopted the issuer-pays model. Several factors contributed to this transition, including increased investor demand for credit ratings, and widespread use of information sharing technology—such as fax machines and photocopiers—which allowed investors to freely share agencies’ reports and undermined demand for subscriptions. Today, eight of the nine nationally recognized statistical rating organizations (NRSRO) use the issuer-pays model, only Egan-Jones maintains an investor subscription service. Smaller, regional credit rating agencies may use either model. For example, China's oldest rating agency, Chengxin Credit Management Co., uses the issuer-pays model. The Universal Credit Ratings Group, formed by Beijing-based Dagong Global Credit Rating, Egan-Jones of the U.S. and Russia’s RusRatings claimed they are going to uses the investor-pays model.

Critics argue that the issuer-pays model creates a potential conflict of interest because the agencies are paid by the organizations whose debt they rate. However, the subscription model is also seen to have disadvantages, as it restricts the ratings' availability to paying investors. Issuer-pays CRAs have argued that subscription-models can also be subject to conflicts of interest due to pressures from investors with strong preferences on product ratings. In 2010 Lace Financials, a subscriber-pays agency later acquired by Kroll Ratings, was fined by the SEC for violating securities rules to the benefit of its largest subscriber.

A 2009 World Bank report proposed a "hybrid" approach in which issuers who pay for ratings are required to seek additional scores from subscriber-based third parties. Other proposed alternatives include a "public-sector" model in which national governments fund the rating costs, and an "exchange-pays" model, in which stock and bond exchanges pay for the ratings. Crowd-sourced, collaborative models such as Wikirating have been suggested as an alternative to both the subscription and issuer-pays models, although it is a recent development as of the 2010, and not yet widely used.

Oligopoly produced by regulation

Agencies are sometimes accused of being oligopolists, because barriers to market entry are high and rating agency business is itself reputation-based (and the finance industry pays little attention to a rating that is not widely recognized). In 2003, the US SEC submitted a report to Congress detailing plans to launch an investigation into the anti-competitive practices of credit rating agencies and issues including conflicts of interest.

Of the large agencies, only Moody's is a separate, publicly held corporation that discloses its financial results without dilution by non-ratings businesses, and its high profit margins (which at times have been greater than 50 percent of gross margin) can be construed as consistent with the type of returns one might expect in an industry which has high barriers to entry. Celebrated investor Warren Buffet described the company as “a natural duopoly,” with “incredible” pricing power, when asked by the Financial Crisis Inquiry Commission about his ownership of 15% of the company.

According to professor Frank Partnoy, the regulation of CRAs by the SEC and Federal Reserve Bank has eliminated competition between CRAs and practically forced market participants to use the services of the three big agencies, Standard and Poor's, Moody's and Fitch.

SEC Commissioner Kathleen Casey has said that these CRAs have acted much like Fannie Mae, Freddie Mac and other companies that dominate the market because of government actions. When the CRAs gave ratings that were "catastrophically misleading, the large rating agencies enjoyed their most profitable years ever during the past decade."

To solve this problem, Ms. Casey (and others such as NYU professor Lawrence White) have proposed removing the NRSRO rules completely. Professor Frank Partnoy suggests that the regulators use the results of the credit risk swap markets rather than the ratings of NRSROs.

The CRAs have made competing suggestions that would, instead, add further regulations that would make market entrance even more expensive than it is now.