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Credit rating industry, success factor in an oligopolistic market

Credit rating agencies provide an independent assessment to securities or issuers. The market for the industry is humongous with nearly $82,000 billion worth of debt securities issued in Q3 2016 as per the BIS (Bank for International Settlements). The industry is poised to grow due to more regulatory pressure, high borrowing cost for an unrated security and worldwide acceptance of a rated security.

The industry is oligopolistic with merely three players namely Moody’s, S&P (Standard & Poor's) and Fitch. These firms have ruled the market for more than 100 years with nearly 95% of the market share. Additionally, other players with minimal market share are A.M. Best, Egan-Jones, Kroll Bond Rating Agency, Rating and Investment Information, Inc., Dominion Bond Rating Service (DBRS), etc.

Moody’s, S&P and Fitch are the dominant players as these were the initial three to be acknowledged as Nationally Recognized Statistical Rating Organization (NRSRO) by Securities and Exchange Commission (SEC). However, in the wake of 2008 financial crisis, SEC added few more names to ensure the integrity of the ratings. But, still, these three agencies have a huge pre-eminence and are considered too big to fail.

In order to retain their dominance in the market, these companies continuously explore potential acquisitions in different geographies, where they do not have an exceedingly strong footing. The obtainment of ICRA (Investment Information and Credit Rating Agency) in 2014 (based in India) and Korea Investors Service in 2016 (based in Korea) by Moody’s and Crisil by S&P in 2005 are evidence of this fact.

In an oligopolistic market, where companies follow a similar revenue model and issuers tend to draw ratings by multiple agencies, it becomes all the more challenging for a company to perform significantly different. Moreover, owing to governmental regulations, all credit agencies more or less follow an identical revenue model known as Issuers Pay Model, this limits the level of differentiation offered to customers. Conspicuously, issuers pay model comprises loopholes that may compromise the integrity of ratings issued. Furthermore, under issuers pay model a fee is charged from the issuer of security as opposed to earlier investor pay model. An issuer can easily influence a rating agency to assign a favourable rating to a security. Consequently, as there is no difference in the services offered, an issuer will not face any difficulty to switch over to other CRAs (Credit Rating Agencies). This may lead to a rigged rating, which could mislead several investors. A glaring example of this was Moody’s and S&P assigned investment grade ratings, which was given to junk bonds and triggered the 2008 financial crisis.

There is a minute scope for the three companies to compete on the basis of revenue as most issuers acquire ratings from all the three CRAs. Additionally, CRAs follow a general fee structure. According to the S&P Global Ratings Fee Disclosure, the fee charged varies with the type of credit rating being issued and complexity of the security being rated. They can also charge an additional fee for an ad-hoc rating requests.  

The revenue of Moody’s and S&P saw a continuous growth during 2012-15 as shown in the above graph. The companies were earning an identical amount of revenue; the slight difference can be attributed to factors such as foreign exchange translation impact, marginal difference in annual fee charges, etc.

Therefore, owing to almost negligible distinction in the products and services offered, the firms need to focus on their operating cost in order to perform better and lead the industry. The operating cost of a CRA is mainly employees in form of analysts and spending on technology through the purchase of software and databases. The use of software and databases can reduce employee cost, but assigning ratings require expertise, thus, companies require numerous experts. According to S&P in order to assign a rating to a large firm or a country anywhere between five to eight experts’ opinion is taken into account.

These three rating companies are sizeable corporations and have been the market leaders for more than 150-200 years, this help to bring economies of scale into their operations. The average cash opex per employee for Moody’s steadily decreased during 2012-15; however, this marginally increased in FY 2015 owing to growth in employee compensation expenses arising out of the acquisition of ICRA. There was an unusual trend for S&P in FY 2014 due to legal penalty and restructuring cost. The firm need to pay $1.6 billion in regulatory settlements, a greater part of this is to be made against a fine slapped on the company for the 2008 financial crisis. In addition, Moody’s operating expense was also expected to increase in FY 2016 as it is also set to bear the fine of $864 million for giving false ratings to risky investment securities.

The impact of the change in opex was humongous as shown in the below graph of EBITDA margin. A drastic increase in cash opex for S&P in FY 2014 translated into a sharp decline of a similar magnitude in EBITDA margin. This means that companies can improve their bottom line by keeping a tab on their costs. Moody’s generated a higher EBITDA margin than S&P during 2012-15, this was due to its ability to optimise costs, while S&P managed to control its expenses in FY 2015.

The need for cost optimisation and bring in different revenue models has become more relevant in the wake of the US government initiatives to bring competitive forces into the market. Thus, following the 2008 crisis, the US government removed the requirement of rating securities or companies by credit rating agencies so that investors understand its real meaning instead of considering it as a mere input variable for an investment decision. Unfortunately, this did not go well with the end users. In 2011, SEC added 8 more names to the list of NRSRO. The aim was to include rating agencies from other nations such as Japan and Canada. This is yet to change the affairs as new entrants will take few more years to break the oligopoly. In addition, regulatory bodies also put a great deal of stress on the code of ethics. The credit rating agencies are required to bring in the code of ethics in their day-to-day operations so that the meaning assigned to ratings remain intact and for the maintenance of value.

In a real sense, credit rating industry is a duopoly and benchmarking the players is tough. However, after examining Moody’s and S&P, Televisory found that the only parameter which is distinguishing is the extent to which operating costs are controlled. Moody’s and S&P have been successful in restricting their costs at an optimal level. Moreover, new entrants face a dual task at their hands, which is to attract issuers with low price or better fees structure and simultaneously confine employee costs and at the same time maintain ‘expertise’. Thus, whether these will be able to break the oligopoly remains to be seen in the near future.

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