by François Masquelier, Head of Corporate Finance and Treasury, RTL Group, and Honorary Chairman of the European Association of Corporate Treasurers
ESMA has issued a ‘Call for Evidence’ to help find ways of increasing competition, broadening choice and minimising conflicts of interests in the credit rating agencies industry. What will the upshot be? Are the suggested solutions really practicable and conceivable? Is it really possible to use restrictive measures to reduce systemic risk and avert the next financial crisis? Some people are quite sure of that, to the potential detriment of ‘real economy’ companies with credit ratings.
Improving the workings of the credit rating agencies industry
ESMA (the European Securities and Market Authority) has initiated a consultation process to gather information from market participants about the workings of credit rating agencies and the structured financial instruments market (as required by law – Regulation [EC] 1060/2009 on credit rating agencies [CRAs]). ESMA wants to gain a better understanding of the competition aspect, the choice aspect and potential conflicts of interests that might arise in the credit rating agencies industry generally, together with the impact of a number of specific measures under consideration for regulating credit rating agencies (CRA). The deadline for responding to this call was 31/03/2015. Once they have been gathered in, these responses should enable ESMA, the European markets supervisor, to issue a recommendation on the subject to the European Commission (art. 39 [4] and 39 [5] of the CRA Regulation).
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ESMA’s objectives
ESMA has several objectives in mind:
- The appropriateness of the current position and any alternative system or systems for remunerating credit rating agencies
- The choice of credit rating agencies and the competition between them
- To see whether it is necessary and appropriate to suggest additional measures to stimulate competition between the agencies
- The impact of the levels of market concentration on the overall stability of the finance industry
- The appropriateness or otherwise of policies, procedures, shareholding ceilings and mandatory rotation for the purposes of keeping down the risk of conflicts of interests
- Disclosure obligations relating to structured financial instruments
- The duration of agreements between CRAs and issuers for the issue of ratings, the mandatory rotation of rating agencies and the exemptions from mandatory rotation
Conversely, the question of any measures aimed at reducing over-dependency on credit ratings (art. 39 [5] g) is not included in this Call for Evidence.
A good idea or a pipe dream?
Trying to increase competition between credit rating agencies by enlisting or setting up new competitors seems to be a very laudable idea. Unfortunately, it would appear to be difficult to conjure up competition out of nowhere for this oligopolistic trio (i.e., Fitch Ratings, Standard & Poor’s and Moody’s). Can anyone reasonably think that unearthing such new competitors and alternative credit rating agencies is a realistic proposal? Of course not! We need to be pragmatic and stop thinking that credible and viable alternatives – European alternatives what is more – might emerge in the short or medium term. The oligopoly is so robust and firmly entrenched that very high barriers to entry protect these three agencies. There is no reason to think that some unknown new entrant could easily compete with them. Competition from an alternative source would seem to be a pipe dream. It is true that it would be good to have other agencies to put pressure on credit rating costs and to improve services. That scenario, however, is rather improbable. It is, nevertheless, a crucial point, because without a larger number of choices there can be no rotation worthy of the name.
Rotation
The idea of rotating agencies, in the same way as statutory auditors (external auditors) are required to do, looks attractive on the face of it. It would help avoid any tendency to acquiescence, stop existing ratings being unquestioned and in the final analysis inject some new blood and have a fresh eye cast over things from time to time. No one could criticise the idea. Unfortunately, in practice there are two major obstacles: there are not enough credit rating agencies for such a rotation, and rotation has a high cost at the time of the initial rating or when a new rating has to be issued.
Taking the first point, even a long rotation period of three or five years would require one or more other agencies to be found. How can a switch worthy of the name take place when there are only three agencies? What happens if you have two credit ratings, or even three? Would you have to shut down for a year or two to try to recover a rating subsequently? The technical impossibility of such a measure is immediately apparent. In absolute terms, why not? In reality, we need to forget about this impractical idea. If the point about increased competition can be resolved, then perhaps the idea might become meaningful again.
The second argument is the cost aspect. Obtaining an initial rating when you are starting from nothing (or starting again from nothing) involves investing time and bearing the cost of support from an adviser or a bank (which will hope for or demand a major role at the next bond issue). This will have a certain cost and there is the risk of not achieving the same rating. You have to have been involved in an exercise of this type to know how much of top management’s energy it consumes, and how high the cost can be – often taking the form of a major ticket given to the bank at the time of the next bond issue. The idea is already much less attractive for the company being rated, which at the end of the day will inevitably have to pay for the initial rating and the annual subscription. Instead of having several ratings, it would be enough to have just one, which would allow the other agencies to take turns in issuing their ratings. This hardly seems practicable or desirable for the issuer, regardless of the advantages for investors.
Imposing a minimum of rotation before having enough competition amounts to putting the cart before the horse. The European Commission should defer bringing in this idea, as it can only be counter-productive. Continuity can have some benefits, and the fact of having several ratings could give greater comfort. Since a rotation between three agencies is technically impossible, the company would have only one rating at a time. Conversely, ensuring that agencies rotate internally, as their code of conduct anyway often requires, can help limit the risk of slackness and acquiescence.
A passport to the capital market
Credit ratings will really come into their own under the massive Capital Market Union project initiated by the European Commission. Surely they are the passports for the trip to capital market land? Without this essential travel document, bond issues will not be possible in many cases. If we want to develop this market to the detriment or at the expense of the bank lending market, we have to strengthen credit ratings because they will become ever more crucial and more in demand by investors than ever before. The capital market is not like the Schengen area of European countries that have abolished passports and border controls. It will, rather, be a journey to a distant destination that is not particularly exotic, but needs the Open Sesame provided by a credit rating. Market practices sometimes even require more than one travel document. You have to show all your credentials to access this market that the European Commission would love to develop and stimulate to grow. You will not be able to travel without a passport. You will therefore need to obtain that little rating made up of three letters or a sign which will speak volumes (in spite of being just a recommendation or opinion) about your financial standing and your ability to repay a loan when it falls due. This rating is the customs or embassy stamp for the financial markets, the thing that will enable you to enter them. Just three letters, but a huge amount of work behind the disclosure of financial and other information, to give reassurance to the agency as to the quality of your credit as an international debtor.
But a credit rating is useful, even for those who do not venture into the financial markets for capital. It gives some reassurance to counterparties that its holder has a certain financial standing. Let us consider a rated group giving its corporate guarantee to a third party, a landlord or a supplier for example, that its subsidiary XYZ will indeed repay or clear its debt. Such a guarantee is extremely useful because everybody recognises it and it can be enough to reassure a counterparty that does not know you. Here again, it is a level of reassurance but by no means an absolute guarantee. It is indeed this detail of the rating – which is nothing more than an opinion – that will leave a few naive investors aghast, because they had believed that a rating meant a guarantee of solvency. It is only an opinion, which some people might wrongly take as a certainty. That is their risk. Since we can’t operate on the capital market without a rating, we can understand why in spite of it all ESMA wants to satisfy itself that this passport should be of good quality.
Does the ‘Issuer-Payer’ model have any justification?
ESMA’s document raises this question by asking what possible choices might be considered. Nobody thinks that a restaurant should pay the Michelin guide or Gault & Millau for awarding it stars. Independence would be impossible. Conversely, the fact that the issuer pays does not imply a risk of the issuer influencing the rating agency. The rating agencies remain neutral and independent even though they work on a financial model based on commission. Replacing this system by an ‘Investor-Payer’ model would be difficult. Investors might use it, but on an occasional basis and only when needed. Which of the investors would pay, and which would not pay? This method would be unworkable. It would end up with less complete coverage of rated companies. There would be discrimination against the smallest or least attractive entities. The state-controlled or European model could be an alternative, but at the end of the day it will have to find remuneration for the government from elsewhere. How can commissions be received fairly and impartially?
Finally, the cost of rating is built into the total financing cost. These expenses are a fairly small component of the cost of finance as a whole: we are talking about a few basis points at most. Any other model would constitute a break with long-standing market practice. It would bring with it a risk of unfairness, and a number of other disadvantages (depending on the formula adopted). This idea, too, needs to be quickly forgotten. We might compare this model to that of the television where advertising is paid for by the advertiser (i.e., the issuer) which thereby funds the broadcasts and the free-to-air TV content from which the beneficiary (i.e., the investor) benefits.
Other potential improvements
Amongst the other ideas received, the Commission wants to satisfy itself that there are no inappropriate market practices. Unsolicited ratings have, very happily, disappeared. Companies that show transparency usually have nothing to complain about in the treatment they receive from their agency. Each agency’s internal code of conduct, the IOSCO code and the code put forward by IGTA, have improved procedures and processes, giving better protection to issuer companies being rated (http://tiny.cc/05b0xx). We do not think that this can be much improved. For instance, the recent amendment made by S&P to its method of rating non-financial corporations is, although unquestionably more complicated, a real improvement and refinement in the method of setting a rating. Things are changing anyway, without any regulations being imposed.
“Who rates the raters?”
When rating agencies or their workings come under scrutiny, the question that many people raise is that of their independence. Independence also comes from the shareholders of the agencies. Can the private shareholders of what in the final analysis is a fairly small entity guarantee the quality of the services? On the face of it, this doesn’t make sense. However, it is important to know who controls these rating agencies. Who rates the rating agencies at the end of the day? This is a fundamental question that worries the most sceptical. There would be some benefit in setting up a system that guarantees some minimum level of monitoring of rating agencies and perhaps a European accreditation for awarding permits to ‘rate’ issuers or financial products.
Are they not trying to do too much?
There is a risk that trying to over-legislate to protect investors and meet one of the European priority objectives – providing competition – could be counter-productive and have an adverse influence on a system that may not be perfect, but that has been working quite well for a number of years. What caused the problems in 2008 were not the ratings for the real economy, but rather the ratings for structured products and banks. The Enron affair is now a distant memory. Existing regulations and legislation, reviewed in 2009 and in 2013 (i.e., CRA III) seem to be robust enough to ensure that the system would stand up to another systemic crisis. If we try to do too much, we may well end up worse off. EACT has therefore encouraged ESMA to reconsider some of the ideas and measures proposed. Are they likely to listen to it? (see Call for Evidence’ 3 February 2015 ESMA/2015/233 “Competition, choice and conflicts of interests in the credit rating industry” – www.esma.europe.eu)
