Understanding credit ratings quality

The British Accounting Review 41 (2009) 107–119

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The British Accounting Review journal homepage: www.elsevier.com/locate/bar

Understanding credit ratings quality: Evidence from UK debt market participants Angus Duff a, *, Sandra Einig b,1 a b

Accounting Finance and Law Division, University of the West of Scotland, Ayr Campus, Ayr KA8 0SR, United Kingdom Accounting, Corporate Governance and Information Management, Business School, Oxford Brookes University, Oxford OX33 1HX, United Kingdom

a r t i c l e i n f o

a b s t r a c t

Article history: Received 20 October 2008 Received in revised form 5 February 2009 Accepted 10 February 2009

This study seeks to identify: (i) the demand for corporate bond ratings provided by credit ratings agencies (CRAs); (ii) how issuers select CRAs; and (iii) to better understand ratings quality, a term widely used by commentators, politicians and regulators, but underexplored in the academic literature. Interviews identify the principal source of demand for rating information is to reduce agency conflicts between issuers and investors. Issuers typically engage between one and three credit ratings agencies to rate their debt, implying a heterogeneous demand for ratings services, and different levels of ratings quality. However, ratings quality extends beyond competence and independence to include factors relating to professional judgment, communication, transparency, and the quality and continuity of analytic staff. Findings were discussed in the light of the ongoing international policy debate concerning CRAs. Ó 2009 Elsevier Ltd. All rights reserved.

Keywords: Credit ratings Credit ratings agencies Credit ratings quality

1. Introduction

We live again in a two-superpower world. There is the US, and there is Moody’s. The US can destroy a country by leveling it with bombs: Moody’s can destroy a country by downgrading its bonds. (Friedman, 1995 cited in Sinclair, 2005) The global credit crisis of 2008, preceded by the sub-prime mortgage crisis in the United States (US) has placed credit ratings agencies (CRAs) under the spotlight. CRAs are perceived to have failed the market (Duff and Einig, 2007) by problems in rating structured finance securities. Subsequent to the subprime debacle, issues relating to the quality of ratings have been raised by a wide range of commentators, politicians and regulators, with demands for greater regulatory measures and accountability to improve the quality of ratings work. Criticism of CRAs is hardly new, with their seeming inability to predict the 1997 Asian financial crisis or the collapse of US energy corporation Enron at the start of this century. For example, each of the three major CRAs provided Enron with investment grade ratings until just four days prior to its collapse. Credit rating agencies (CRAs) provide an independent evaluation of the probability of default on a bond issue and review the assessment in the light of economic events. In addition, the CRAs provide information to debt market participants beyond those publicly available sources (e.g., Reiter and Zeibart, 1991; Ederington et al., 1987). Consequently, CRAs provide a valuable

* Corresponding author. Tel.: þ44 1292 886 296. E-mail addresses: [email protected] (A. Duff), [email protected] (S. Einig). 1 Tel.: þ44 1865 485 700. 0890-8389/$ – see front matter Ó 2009 Elsevier Ltd. All rights reserved. doi:10.1016/j.bar.2009.02.001

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A. Duff, S. Einig / The British Accounting Review 41 (2009) 107–119

role to stakeholder groups such as issuers, investors, and regulators, allowing credit markets to function properly. For the purposes of this paper, CRAs are conceived of as the (then)2 five Nationally Recognised Statistical Rating Organizations (NRSROs) Moody’s, Standard & Poor’s, Fitch, A.M. Best, and Dominion Bond Rating Services. An aim of this paper is to apply the theoretical lens of the extensive extant financial gatekeeper literature to better understand the relationships CRAs have with issuers, investors, and other market participants. The paper makes a conceptual contribution in two ways. First, it contributes by employing interviews with 14 key credit market participants as illustration, allowing us to get closer to the theoretical constructs (Sigglekow, 2007). Second, it contributes by extending gatekeeper perspectives from the audit literature to the under-explored ratings industry. The present study has three objectives. First, it explores demand for ratings from UK debt market participants in the United Kingdom (UK). The UK is chosen as the majority of prior research has focused on the United States (US), notable exceptions being Adams et al. (2003) and Barron et al. (1997). As recognized CRAs operate on a global basis, it is likely insights from the UK will be generalisable to other jurisdictions. The second objective is to assess how UK issuers go about commissioning a CRA to rate a debt security. The final objective is to explore issues relating to ratings quality. The remainder of this paper is structured as follows. The following section provides a review of the literature considering ratings quality, including the contextual setting against which the results of the study are set. These include the demand for ratings information and perspectives from the financial gatekeeper literature, which have some potential to inform thinking on CRAs and ratings quality. Recent developments in regulation, self-regulation, and monitoring within the CRA industry are also considered. Section 3 identifies the research questions. Section 4 explains the method applied in the present study. The results and discussion are presented in Section 5. The final section summarizes and concludes. 2. Background 2.1. The ratings industry According to Cantor (2004, p. 2565) research considering credit risk has been ‘‘one of the most active areas of recent financial research’’, with significant efforts deployed to analyse ‘‘the meaning, role, and influence of credit ratings’’. However, issues concerning the demand for ratings information and the conceptualization of ratings quality remain relatively unexplored (see Frost, 2006; Duff and Einig, 2007, in press). CRAs provide a service at the invitation of client companies to provide an independent assessment of the credit quality of a company’s debt security or securities.3 The unique selling proposition of the CRA is to distil a multitude of credit information to a single letter on a credit quality scale (e.g., AAA denoting very low probability of default). Over the life of the debt security, the CRA monitors its credit quality. When creditworthiness increases an upgrade may be issued. In the case of deteriorating credit circumstances a downgrade would be issued. When the issuer has solicited the rating, CRAs have privileged access to their client’s senior management and other confidential information sources. By virtue of access to unpublished information and their independence, CRA opinions are of interest to the investment community. Our research views CRAs as comparable with suppliers of audit and assurance services, operating in an unusual economic market in which the CRA (or auditor) is a central participant, whereby a significant source of demand for ratings comes from third parties (e.g., fixed-income investors) who only pay indirectly for the required services. The client (debt issuer) is often a forced participant in the market, required by investors to engage the services of a CRA to obtain a rating of the credit quality of its securities. Auditors and CRAs are conceptualised as financial gatekeepers on whom the board of directors rely to properly advise and warn it of danger (Coffee, 2006). Despite criticisms of the role CRAs have played in global financial markets over the past decade, paradoxically, issuers of debt securities, investors, and government regulators (e.g., the SEC in the United States (US), and the United Kingdom’s (UK) Financial Services Authority) have increased their reliance on the opinions of CRAs for corporate financing, investment decisions, and risk management (Baker and Mansi, 2002). The Basel Committee on Banking Supervision has increased the role given to CRAs in its revised capital adequacy framework (Basel II) by basing its standardized approach for credit risk measurement on external credit ratings. The ratings industry is effectively an oligopoly, dominated by two NRSROs (Moody’s and S&P). Moody’s and S&P account for 80% of the market, while Fitch’s share is only 15% (Duff and Einig, 2007). The closest rivals to this oligopoly are A.M. Best, specializing in insurance, and Dominion Bond Rating Services, with a Canadian focus. However, it is important to note that a number of much smaller specialized CRAs exist. A recent survey of the ratings industry identifies there are more than 130 CRAs worldwide (Basel Committee, 2000). These CRAs vary considerably in terms of size, industry coverage, regional focus, and methodology. In the US, this market structure coupled with recent perceived failures of CRAs has motivated some parties (e.g., US Congress) to create legislation to increase competition. Further issues of concern include the business model of the CRAs,

2 From September 2007, the Securities and Exchange Commission (SEC) also recognized Japan Credit Rating Agency, Ratings and Investment Information, Egan Jones Ratings, and LACE Financial. 3 IOSCO (2004) define CRAs as ‘‘those entities whose business is the issuance of credit ratings for the purposes of evaluating the credit risk of issuers of debt and debt-like securities’’.


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where issuers pay for a rating, but the users of the ratings are investors. This creates an inherent conflict of interest (Duff and Einig, in preparation; Smith and Walter, 2002). In addition, CRAs offer various ancillary business services ranging from provision of market data, ratings of funds, and equity ratings to ratings advisory services and risk management solutions. There is some concern that these services could compromise the CRAs’ independence. The Credit Rating Agency Reform Act 2006 (CRARA) was enacted in 2007, with the motivation of improving the quality of ratings by fostering competition, transparency, and accountability in the rating industry. Specifically the legislation: (i) establishes a clear route to NRSRO designation, which was perceived as a barrier to entry; and (ii) provides SEC oversight of the CRAs to improve ratings quality, protect against misuse of non-public information, and prevent conflicts of interest. Outside the US, self-regulatory approaches have found favour. The International Organization of Securities Organizations (IOSCO) has developed a Code of conduct (IOSCO, 2004). All the major CRAs have agreed to sign up to its provisions, which are monitored annually by the Committee of European Securities Regulators (CESR). However, in the light of the related US subprime and credit crunch crises politicians and regulators are seeking to introduce formal regulation of the CRAs work. In particular, the European Commission has published extensive proposals in this area. These include the creation of a panEuropean regulator and detailed proposals to oversee ratings processes and in certain circumstances intervene in ratings decisions. The EC’s proposed regulation of processes approach is in contrast to the regulatory approach adopted in the US, where the focus is more on the oversight of outputs. Finally, the scale of the global financial crisis and its antecedent, the sub-prime mortgage failure, has attracted the attention not just of regulators, but politicians, commentators, and academics. In an attempt to use the extant literature and collective wisdom of the academic community to reform the role of CRAs in the securitization process, the Financial Economists Forum (FER) (2008) identified some key improvements. These include, first, an increase in CRA incentives to increase transparency of modelling processes and holding CRA management accountable for negligence. A second reform would be to reduce the role of private ratings in regulation issued by public entities.

2.2. Demand for rating services A wide range of parties use the information provided by CRAs (Boot et al., 2006). These include: issuers of debt who request a rating; investors purchasing short- or long-term debt (‘buy-side’ participants); investment banks marketing debt securities (‘sell-side’ participants); trade and commodity financiers assessing risk in individual transactions; and regulators, assessing the credit risk associated with an institution’s assets and liabilities. The diverse nature of users of ratings information creates four potential sources of demand. First, a published rating reduces agency conflicts that exist between owners, managers, and debt holders. A public rating reduces information asymmetry effects (Millon and Thakor, 1984) between the issuer and key stakeholder groups. In undertaking an independent review of the probability of default of a debt issue, the CRA is able to provide objective and independent information to the market about the issuer’s future prospects. The selection of a credible CRA, or multiple CRAs, should signal management’s quality and integrity (cf., studies of auditors, Datar et al., 1991; Willenborg, 1999). A CRA’s review of the prospects of the debt issuer, including all public and non-public information sources, as an independent exercise enhances stakeholders’ perceptions of the ability of the organization to service the debt. A solicited rating allows the CRA to incorporate a range of soft qualitative information into their assessment, beyond that found in the publicly available financial reporting information (Butler and Rodgers, 2003). This leads to the following proposition: P1a: Issuers seek a credit rating to reduce information asymmetries, thereby reducing their borrowing costs A second source of demand comes from those organizations which adopt treasury policies which specifically prohibit investment in non-investment grade bonds. Without an appropriate rating, investor appetite for a public debt issue would be lower than if a rating from a credible CRA had been sought. Investor policies are supplemented by a long-history of regulatory demand for financial institutions to hold securities classified as investment-grade by a NRSRO, see Cantor and Packer (1997) for a history of regulatory use of ratings. Therefore, the requirement for a rating becomes institutionalized within the organization’s investment policy. P1b: Investors’ internal policies require a rating as a precursor to investing in debt securities. A third source of demand comes from other interested parties who use ratings information for decision-making purposes. These might include the evaluation of trading partners, assessment of financial counterparties (e.g., in financial instruments such as swaps), and appraisal of business partners (e.g., where an organization enters into a joint venture agreement or strategic alliance). Consequently, P1c: Being rated makes the issuer more attractive to other trading partners. Fourth, small investors are less likely than professional investors to be able to assess the plethora of quantitative and qualitative information concerning the credit quality of a security. The availability of a rating makes the smaller investor more able to compete with professionals. Thus, the adverse selection risk of trading with better-informed professionals is reduced (e.g., Glosten and Milgrom, 1985; Diamond and Verrecchia, 1991; and Leuz and Verrecchia, 2000). The information quality provided by a rating should reduce the risk to less-informed investors due to adverse selection, leading to a reduction in the issuers’ cost of equity capital. P1d: A rating reduces adverse selection problems, making the rated security more attractive to a wider selection of investors.

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2.3. CRA selection The differential size and needs of debt issuers lead to three factors which may affect the selection of specific or multiple CRAs. First, a CRA has access to the company’s management, and is therefore able to access non-public information about the organization’s future strategy and prospects. Consequently, the information gap between issuers and investors is reduced. The effect of reducing this information asymmetry is to reduce the risk premium associated with a debt issue, lowering the margin payable on the issue, and reducing the issuer’s overall cost of capital. On a related point, DeAngelo (1981) identifies that different levels of agency costs exist that give rise to a heterogeneous demand for audit quality. Consequently, demand for ratings quality should be higher when information asymmetries are higher. Furthermore multiple ratings are common for many debt securities (e.g., Cantor and Packer, 1996). ˇ ada (1999) describes the safeguarding mechanisms which exist between two parties involved in contractual Arrun exchange, e.g., where a CRA contracts to provide ratings information for a debt issuer. In this contractual exchange, quality is maintained by both explicit and implicit contracting safeguards. With an explicit safeguard, the failure of the CRA to rate at an appropriate quality could result in litigation and legal sanction. With implicit contracting, the penalty for breach is decided by potential issuers and investors by withdrawing their confidence in the CRA. For CRAs, like auditors, implicit safeguards are likely to be more important, as breach of an explicit safeguard has to be verified by third parties.4 The limited empirical evidence available for the CRA industry suggests reputation-related incentives are sufficient to overcome the inherent conflict of interest within the CRA business model (Covitz and Harrison, 2003). Collectively, this literature suggests two propositions: P2a: Larger issuers in public markets will use the largest CRAs with the highest reputation. P2b: Larger issuers in public markets will use multiple CRAs when undertaking a rating exercise to provide the market with ratings information of the highest quality.5 Credit ratings are used by regulators, e.g., the SEC in the US, to assess capital adequacy and permitted investments for regulatory purposes (Cantor and Packer, 1997). Furthermore, recognized CRAs have become relied upon by government agencies who use their ratings, enabling the CRA to sell a form of regulatory immunity, a regulatory license (Partnoy, 1999). Therefore, P2c: If an institution invests in securities without a suitable credit rating, then it may adversely affect a regulator’s assessment of the institution. Fourth, CRAs can provide services over and beyond rating services, usually termed ancillary services. Ancillary services include providing information on structuring the company’s finances to enhance a rating, subscription services to their ratings information, and new products such as risk assessment of pension funds and corporate governance arrangements. These services are provided in addition to the maintenance of the rating service. Specifically, CRAs can provide feedback about the long-term effects of their approach to risk and advice of the effect of changes in strategy to their perceived risk profile. Furthermore, CRAs can advise on the effect strategic change would have on their credit rating, and consequently cost of capital. P2d: Larger CRAs are able to offer issuers access to a range of additional resources. 2.4. Theoretical approaches The term ‘ratings quality’ is not widely used in the extant CRA literature, despite its regular use by commentators, politicians, and regulators (e.g., CESR, 2005, 2006; European Commission, 2006; US Senate Committee, 2006). To develop a concept of ratings quality, i.e., the quality of ratings information, the audit literature would appear to offer a definition of ratings quality. DeAngelo’s (1981) seminal definition of audit quality focuses on two elements: first, the competence of the auditor (i.e., their ability to identify a breach in the client’s accounting system); and second, their independence (i.e., willingness to report the breach). Therefore, ratings quality could be similarly described as reliant on two matters: the competence of the CRA (i.e., their ability to accurately assess the probability of default on a security); and second their independence (i.e., willingness to downgrade an issuer’s security, or issue a lower rating than the issuer anticipated). Both competence and independence feature in contemporary debate about the CRAs and their role in credit markets. Competence in particular is often framed in terms of the appropriateness of ratings methodologies and their ability to maintain these ratings. The independence of CRAs is often questioned in the light of the ratings industry business model whereby the CRA is remunerated by the party it rates, creating an inherent conflict of interest also apparent in the related financial gatekeeping profession of auditing. This discussion is framed in terms of two propositions: P3a: The quality of credit ratings reflects the technical competence of the CRA and its analytic staff. P3b: The CRA must be independent of issuers and investors to issue high quality credit ratings. The audit literature emphasizes the need to incorporate the auditor’s professional judgment into the auditor’s opinion. ˇ ada (1999) suggests when attempts are made to increase independence by further legal sanctions, independence in fact is Arrun limited to compliance with various verifiable criteria. Therefore, the threat of litigation may encourage a superficial approach to

4 In practice, as the US Congress Committee (2002) has identified, CRAs are practically immune from litigation, unlike auditors in the US, meaning implicit safeguards are likely to be the major quality safeguard. 5 Even prior to the collapse of Enron, WorldCom, and Parmalat, investors were beginning to seek more than one rating.


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auditing, so-called defensive auditing, and reduce its information value. Similarly, we would expect that the threat of legal sanction against CRAs could create ‘defensive ratings’, where the analyst is constrained to base their opinion only on information which could be verified by a court of law. That subjective information which would normally form part of the analyst’s professional judgment is disregarded, as it could not be used as a defence if litigation is generated against the CRA. P3c: A rating should incorporate the professional judgment of the credit analyst beyond a decision derived from the application of a mechanistic methodology. Finally, limited research considers the relationship between the auditee and the auditor. Such studies identify buyer types (Beattie and Fearnley, 1998) and seller types (Beattie et al., 2000) which essentially define the dyadic nature of the relationship between the auditor and auditee, and factors which reflect their negotiations (e.g., Gibbins et al., 2001; McCracken et al., 2008). Limited evidence in the ratings industry points to the value of the inclusion of soft qualitative inside information elicited by the ratings analyst from the issuer’s management team as part of a solicited rating, over-and-above the inclusion of hard quantitative information already in the public domain (Butler and Rodgers, 2003). Therefore, in any analysis of ratings quality we expect qualitative factors relating to the interaction of CRA personnel with credit market participants to be apparent (Duff and Einig, 2007, in press). P3d: The quality of credit ratings is determined by the quality of the relationship between the issuer and the CRA, i.e., the ability of the issuer and analyst to freely exchange information. To summarize, twelve propositions relating to three research questions are explored in this paper. These are listed in Table 1.

3. Method The study was viewed as exploratory in nature reflecting the scarcity of empirical research evidence concerning relations between CRAs, bond issuers, investors, and other interested parties. Much of the prior research considering CRAs has used archival sources (exceptions being the survey-based research of Baker and Mansi, 2002 and Ellis, 1998), and is therefore removed from the participants themselves. The choice of a semi-structured interview as the principal method of data collection is justified by the exploratory nature of the study being undertaken (Easterby-Smith et al., 2008). As part of a larger study considering the role of CRAs in financial markets,6 semi-structured individual interviews were conducted with nine corporate treasurers from UK public limited companies who had recently issued rated securities, two investors, and three other interested parties (see Table 2). The other interested parties consisted of two treasury consultants and a commercial banker specializing in project finance. All interviewees are highly knowledgeable of the ratings process. Each of the issuers had regular contact with at least one CRA and usually several. Investors subscribed to ratings agency information services and were active users of this credit ratings research conducted by the major CRAs. The treasury consultants provided advisory services to issuers seeking a rating, in addition to offering ad hoc services such as training in ratings methodologies and rating forecasting. The commercial banker made use of ratings information as part of credit analysis activity conducted for lending purposes. Interviews were conducted between April 2005 and June 2005. All 14 interviewees were from different companies. Interviews were arranged with the interviewee directly. Table 2 identifies the size of the organization, their industrial sector, and where appropriate, the corporate bond rating of the organization at the time they were interviewed.7 Participants were enlisted from a voluntary working party organized by a UK professional body to consider its response to regulatory initiatives being developed by the SEC and the International Organization of Securities Commissions (IOSCO). Therefore, interviewees were chosen for their knowledge and active interest in the function of the credit ratings agencies and their ratings. Issuers represent a range of UK industries of different sizes, and issue investment-grade securities of varying credit quality. Although our selection of participants may not be statistically representative, we do not believe the views expressed by interviewees do any serious injustice to the wider population of those market participants who directly or indirectly use corporate credit ratings. Furthermore, accessing an industry working group provided us with an invaluable insight into how knowledgeable market participants interact with the ratings industry. Typically, the interviews lasted between thirty minutes to one hour, and were conducted face-to-face in the interviewees own premises. Each interview was recorded using a dictation machine and subsequently transcribed by the authors of this paper. Before the start of each interview, each interviewee was provided with a statement of the objectives of the project, background information, and a list of possible discussion points and questions. The interviewer made a conscious effort not to influence the respondents’ views with personal perspectives. Participants were not restricted to these topics and were encouraged to expand on other issues that they felt were important. Finally, interviews were conducted on a strictly confidential basis.

6 Reported as a research monograph for the Institute of Chartered Accountants of Scotland (Duff and Einig, 2007). The monograph reports questionnaire findings relating to features of the ratings process, market participants’ use of ratings and CRAs, and associated policy implications of the results. 7 An explanation of the meaning of the ratings is identified in Table 1.

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Table 1 Summary of research questions and propositions. RQ1: How do debt market participants perceive the demand for ratings information? P1a Issuers seek a credit rating to reduce information asymmetries, thereby reducing their borrowing costs. P1b Investors’ internal policies require a rating as a precursor to investing in debt securities. P1c Being rated makes the issuer more attractive to other trading partners. P1d A rating reduces adverse selection problems, making the rated security more attractive to a wider selection of investors. RQ2: How do issuers select CRAs to rate their securities? P2a Larger issuers in public markets will use the largest CRAs with the highest reputation. P2b Larger issuers in public markets will use multiple CRAs when undertaking a rating exercise to provide the market with ratings information of the highest quality. P2c If an institution invests in securities without a suitable credit rating, this may adversely affect a regulator’s assessment of the institution. P2d Larger CRAs are able to offer issuers access to a range of additional resources. RQ3: What are the determinants of ratings quality? P3a The quality of credit ratings reflects the technical competence of the CRA and its analytic staff. P3b The CRA must be independent of issuers and investors to issue high quality credit ratings. P3c A rating should incorporate the professional judgment of the credit analyst, beyond a decision derived from the application of a mechanistic methodology. P3d The quality of credit ratings is determined by the quality of the relationship between the issuer and the CRA, i.e., the ability of the issuer and analyst to freely exchange information.

4. Findings 4.1. Demand for ratings information All 14 interviewees identified the main reason for commissioning the services of a CRA was to gain access to capital markets. For example: Because investors, we are told, need a rating when they look at our credit. Also for us, because we work in a very controversial industry (name of industry). So we try to ensure in everything we do with our investor relations, everything we do is to help the investment vehicle. And if it means a rating, it is a rating. (Case G, issuer) Therefore a rating could be seen as a precursor to undertake a successful public issue of debt. Ratings are particularly valuable to certain classes of issuers, for example: Banks are massive issuers of debt. And ratings are absolutely crucial to banks. In fact most banks seem to manage their balance sheet with a rating objective in mind (Case O, OIP) The ratings were viewed as essential by all interviewees, particularly in UK and US markets; without a rating an issue could not be successful. Only one interviewee identified ‘‘you can have an unrated issuance, I just think the pricing is better’’ (Case I, issuer). Therefore, substantial support was found from all parties to support the proposition (P1a) that issuers seek a rating to reduce information asymmetries between borrowers and investors to reduce borrowing costs. Another identified that ‘‘some markets don’t allow new deals without a rating being issued’’ (Case D, issuer). Case D also hinted, as a result of the well-publicized corporate failures at the start of the century, that ‘‘ratings had become less important

Table 2 Interviewee, job role, industrial sector, size, CRAs used, and credit rating. Case Position of interviewee

Category

A B C D E F G H I J K L M N

Issuer Food Issuer Packaging Issuer Food Issuer Transportation Issuer Transportation Issuer Drinks/Tobacco Issuer Drinks/Tobacco Issuer Transportation Issuer Drinks/Tobacco Investor Private brokerage Investor Private investment company Other interested party Self-employed Other interested party Self-employed Other interested party European commercial bank

Treasurer Treasurer Treasurer Treasurer Treasurer Treasurer Treasurer Treasurer Treasurer Credit research and analysis Credit research and analysis Treasury consultant Treasury consultant Project financier

Sector

Market capitalisation CRAs (£billion) employed 10

Note: Bond ratings expressed in Moody’s terminology. Case C’s S&P rating was BBB (i.e., equivalent to Baa2).

Moody’s, Moody’s, S&P Moody’s, Moody’s, Moody’s, Moody’s, Moody’s Moody’s, N.A. N.A. N.A. N.A. N.A.

S&P S&P

Long-term Corporate Credit Rating

Baa2 Baa3 Baa2 S&P, Fitch Baa3 S&P Baa2 S&P, Fitch A3 S&P, Fitch Baa1 Baa3 S&P Baa3 N.A. N.A. N.A. N.A. N.A.


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over the past five years as investors have improved their own credit processes’’. One interviewee identified their internal policies meant that they had to seek two ratings before an issuance. Therefore, some backing was found for the proposition (P1b) that internal policies provide a source of demand for ratings information. Our evidence indicates this can come from borrowers as well as lenders. In the case of investors, ratings information was seen as something to supplement the investment decision. Usually large asset management groups conduct their own analysis, and are keen to stress that they do not make decisions on the basis of ratings information alone. It’s part of the overall process. From my perspective I look at companies on a very similar basis to the rating agencies, because it is traditionally how you look at companies’ business. You look at their financials, which is exactly what the ratings do. (Case J, investor) However, investors do take account of the CRA’s view as the rating will be reflected in the price of the debt security. For example, if there is an issue which could prompt a downgrade, the question becomes to what extent will the rating move the price down? Therefore, although investment in fixed-income securities may be independent of the CRA’s views, changes in ratings information will affect a securities valuation, which means the rating will require monitoring. This effect is compounded by the likelihood that smaller investors may undertake less extensive research: I don’t necessarily think that every participant in this market does the same level of research. So you do have a level of reactivity to any move in a rating. (Case J, investor) Another investor identified: Regardless of whether they know the issuers or not, ratings, help provide a degree of comfort when you’re dealing with issuers that you haven’t particularly looked at or researched. So, I think, you know, it’s extremely important for investors. (Case K, investor) Therefore, some support was found for the idea (P1d) that ratings reduce the risk of adverse selection, i.e., they provide a useful decision-support tool for smaller investors. However, ratings also provide useful information for sophisticated credit investors as they determine bond pricing. The increased use of CRAs’ ratings meant that commercial banks could reduce the costs of the internal credit function. However the consequence of this was felt with the corporate failures in the early part of this century: Now I think there has been a realization that actually we still need to keep a significant and important credit function and to be able to do all the analysis ourselves and we can’t just rely on the credit rating agencies and their ratings. I think companies themselves – talking to treasurers – it’s clear that they have realized how vulnerable they were becoming to rely on may be two entities to rate all their financial instruments (Case N, OIP) Case N’s comments touch on issues related to the proposition that ratings are used by other external parties (P1c). In this case, ratings are used to supplement, or even supplant, an internal credit function in banks. However, no other interviewees identified the utility of ratings to other third parties, suggesting third parties’ use of ratings (P1c) is not as extensive as we expected. Or alternatively, this use is less apparent to major credit market players. Therefore, it seems ratings are an integral part of the debt issuance market. As disintermediation continues the demand for ratings information will continue and grow.

4.2. Issues concerning the selection of CRAs All borrowers used some combination of the three main CRAs: Moody’s, S&P, and Fitch. Therefore, perhaps the most unsurprising finding of this research is that issuers seek to employ those CRAs with the highest reputation (P2a). Of the nine issuers, four employed both Moody’s and S&P, and three used Moody’s, S&P, and Fitch. Only two interviewees (Cases C and H) used just one CRA, see Table 2. Of the two using a sole CRA, one anticipated engaging a second, and the other planning to use another CRA if they issued in public debt markets. Three reasons were apparent when considering the choice of CRAs. First, market concentration within the ratings industry means issuers felt they had little choice but to engage Moody’s and S&P, as Case B (issuer) put it: Mostly it is required that you have two ratings. There are only four to choose from, the primary ones are S&P and Moody’s, and those are the two used. Second, who rates an issuer is largely historical. An important part of the CRA-issuer relationship reflects CRAs ongoing commitment to maintaining the rating. Even in the event of a dispute where an issuer declining to pay the fee, the CRA would continue rate on an unsolicited basis. As Case D explained: ‘‘once you have debt rated by them, they will still continue to cover you.’’ Therefore, having engaged a CRA, the relationship is likely to last for the future of the rated security, which could be many years.

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Third, when the issuer has just started the process of seeking a rating, the CRA they chose was often the one with which the treasurer had personal experience. In such instances, relationships between the individual and the CRA were of importance: The agency we chose I have dealt with in the past. I was quite comfortable whereas in the previous role I’ve had some fairly acrimonious discussions with the other two. There are really just three agencies. So I suppose it is logical that we used the one I was happiest with (Case C, issuer) A range of issues emerge when considering using a third CRA. All issuers identified there would be costs in terms of additional fees8 and management time in ‘‘getting an agency up-to-speed’’ and similar education and communication metaphors used by other interviewees. Two reasons were cited for engaging an additional (third) CRA. First was a belief that different CRAs use different quantitative matrices and assess risk differently, which provides broader coverage. Hiring a third CRA provides another view using objective criteria of the probability of default on the bond. If there was a disagreement, two CRAs were likely to agree and provide a clear view. The extent to which this was driven by investors is, however, unclear. On the basis of the interviews, it suggests that a decision to engage a third CRA could be due to some tensions with one or both of the other two CRAs used. For example, Case F (issuer) identified dissatisfaction with one of the two CRAs engaged in their assessment of an existing debt issue: The reason we have three is really because we were unhappy with the analysis that [CRA 1] carried out. And they rated us two notches below [CRA 2] which we felt was inaccurate. And so for our own confidence we took the [CRA 3] and they came to the same rating as [CRA 2]. (Case F, issuer) The second reason an additional CRA could be used was when a smaller CRA specialized in particular market or region. Case G illustrated the point: ‘‘we were led to believe that Fitch is probably more relevant if you are looking to issue in the United States’’. Therefore engaging a third CRA can improve the issuer’s status if that CRA has a reputation in a specific market. This presumably is a major motivation for issuers engaging the (then) two other NRSROs: Dominion Bond Ratings Services (DBRS), based in Canada; or A.M. Best, specializing in insurance. It seems therefore that the use of multiple CRAs does indicate heterogeneous demand for ratings, with certain ratings required in specific markets (P2b). No interviewees specifically mentioned the use of ratings by regulatory authorities (P2c). It could be regulators’ use of ratings is taken as a given by all parties. Alternatively, it could be that participants are oblivious to the use of ratings by supervisory authorities. However, it seems likely that market knowledge of the wide-scale use of ratings is limited, as identified earlier with the limited support found for proposition P1c. Finally, the nine issuers were asked about the usefulness of CRAs providing additional services beyond corporate ratings and structured finance. Two interviewees specifically identified the primary purpose of the CRA was to assess the probability of default and express their opinion. That is, CRAs should adhere to their core competence of publishing ratings information and try to avoid moving into other areas. Examples of other areas mentioned by participants included ancillary ratings services, rating equities, and risk assessment of pension schemes and corporate governance. It appears that the ability of CRAs to offer access to resources beyond ratings (P2d) adds little to issuers’ decision-making processes when selecting CRAs. 4.3. Ratings quality An explicit aim of this research was to consider the applicability of audit theory to the ratings industry. Specifically we asked participants how applicable DeAngelo’s (1981) dual competence-independence construct was to the ratings industry (P3a, P3b). All interviewees emphasized the competence of the CRA related to the abilities of the people they engaged on the rating. In general, issuers communicated a satisfaction with their CRA contacts but were more equivocal about the competence of the CRA itself. For example, Case G explained that ratings influenced the company’s strategic planning. Consequently, this affected how ratings were perceived: Certainly the individuals have been superb, very, very, good. Bright individuals. One could question sometimes the framework within which they work. And also the somewhat naı¨ve approach towards the issuer saying well, the rating is just another sign how you do your business.. . it’s not central, but it’s not peripheral, it’s an issue you have to take into account when you’re making a major business decision. (Case G, issuer). Thus competence is constructed in terms of the CRAs’ methodologies along with staff factors. When negative issues were raised relating to the competence of the CRA, they tended to relate to the experience of the analyst (five cases). As Case E (issuer) described: It depends on the credit analyst to a certain extent, because with respect to [CRA 1] we’ve found a senior analyst moving on and we almost had to retrain, from my point of view, the junior analyst that then stepped in and we still don’t believe that she has a sound grounding and understanding of our business. Our finance director has been quite appalled at some of the comments we’ve seen in draft statements they wanted to put out and we had to do a lot of work to try and get them to rewrite sections where we don’t think they are concentrating on the right areas and the fundamentals

8 Although the motivation for seeking a rating is to reduce the overall costs of debt, ratings fees in themselves are not inconsequential. Langohr and Langohr (2008) identify Moody’s charges fees of 4.5 basis points (bp) on the initial $500 million, with an additional 3 bp payable on issues in excess of $500,000.


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of the business. Whereas [CRA 2], the analyst has been there for many, many years, he knows our business. I think, he’s a more mature, a more experienced person, there’s more consistency there. Of course, Case E’s comments present just one side of the story. An alternative scenario is that CRA1’s analyst has a clear view of the issuer’s business and is unwilling to bow to pressure from the issuer, i.e., she is asserting her independence. By the same token, the ‘‘experienced’’ analyst at CRA2 could have an overly cosy relationship with the treasurer, and the ‘‘consistency’’ of outlook could reflect an unwillingness to downgrade Case E’s rating, or produce a more equivocal credit report. Two interviewees identified the problem of analytic staff turnover, which broke continuity in the relationship with the CRA. Both voiced a view that turnover of analysts was attributable to the perception that working in a CRA was less lucrative or prestigious than other financial institutions9: They continually face the problem that their staff are drawn from the banking community and that in difficult times for the banking community working for a rating agency is seen as a stable job. And when the economy picks up are there are good paying jobs with good bonuses in banking, (so) the good ones go back. (Case B, issuer) Consequently substantial support was found for the proposition (P3a) that technical competence, of the CRA and its staff, was a key determinant of ratings quality. All interviewees perceived CRAs as completely independent. This was expressed in three ways. First, seven interviewees identified CRAs have ‘‘a sufficiently large base. not to be reliant on a particular issuer’’ (Case A, issuer). Therefore, no one issuer creates a sufficient proportion of the CRA’s profit to justify risking its reputational capital with an inflated rating. Second, a notable feature of how CRAs operate is their desire to form an opinion independent of other CRAs and analysts. Two treasurers specifically identified the degree of anonymity CRA analysts possess and their lack of contact with CRAs working in other agencies. For example, one interviewee identified CRAs were individually unwilling to attend a presentation potentially attended by other CRAs. Another articulated this need for independence thus: I’ve never had any problems with considering them to be conflicted in some way. They go to great length to distance themselves from any other thinking, if you like, in terms of looking where others are rated. I was hosting a function where I had the rating agencies there as well and I think they genuinely didn’t know each other. The analysts had never met before. I think that is an encouraging example. So, I’ve never come across any evidence that they had been conflicted in any way (Case G, issuer) Third, interviewees (three cases) drew a parallel with the audit industry and expressed the view that CRAs had fewer independence issues than the accountancy profession. Case J (investor) articulated the position: It’s a big step, for example, for an auditor to step away from a company and say no. either I will qualify these accounts or I will not sign them at all. I think there has to be something fairly major before an auditor will actually qualify an account. So I think the agencies are slightly better, because their output is slightly different. Apart from the standard, you know, the auditors’ letters is in the back of the accounts. Their output is slightly different. They can actually make a comment, you know, that something might be difficult to gauge or difficult to see through or whatever. They can actually adjust their comments. In conclusion, unanimous support was found for the proposition that CRAs needed to be completely independent (P3b). No evidence was found to suggest that CRAs were anything less than independent, with evidence that they were prepared to stand by the courage of their convictions. However, a significant finding of our interview-based research was that competence and independence alone were not enough to describe quality in the provision of ratings information. Beyond competence and independence, interviewees identified a number of other important characteristics. All interviewees believed the dual definition provided a basic summary or prerequisites for a definition, with seven indicating in some ways that it didn’t go far enough. Ways in which the definition could be extended included: consistent methodology (4 cases); transparency (3 cases); internal processes within the CRA to develop and maintain the rating (3 cases); high quality staff (3 cases); timeliness of ratings information (2 cases); need for regulation (1 case); communication with investors (1 case); global coverage (1 case); and openness and honesty (1 case). As identified earlier, interviewees perceive transparency as a key issue for CRAs. In general, interviewees felt the quantitative element of the ratings process was well-documented by CRAs. However, different treasurers had differing views on different CRAs, suggesting their experience of an individual CRA was situation-specific depending largely on who the lead analyst was assigned to the rating and their experience and individual characteristics. Overall, there was a feeling that transparency was ‘‘getting better’’, with CRAs making greater efforts. One approach which was starting to be used by some CRAs was described by Case E (issuer): I’d say, [CRA 1] are a lot better. Last month they came in and gave us a presentation. It wasn’t one that we had requested. And it was very good in that they shared where we were, how we compared against our peer group. They shared their forecasts of some of the key financial ratios and actually graphically set out the bands or the thresholds, you know, if we

9 The perception that working for a CRA is less lucrative or prestigious than a bank or fund manager has been mentioned anecdotally to the authors in a number of conversations with debt market participants.

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moved above either thresholds, the effect that would have on the rating. And that was the first time I’ve seen anything like that in 13 years and its 14 years since we’ve been rated. So that was greatly appreciated, but we haven’t been offered anything like it by [CRA 2]. One area where the CRA’s opinion seemed less than transparent concerned the qualitative side of the assessment (identified by four cases), e.g.: The difficulties arise in that context where there are some very subjective factors and at the end of the day one has to accept that they are entitled to make their mind up and if the way in which they make their mind up on a particular matter happens to be different to the way I would make my mind up, I just have to accept that. I might not like it, but that’s just the way they come to a position. It’s not completely simple and transparent, but that’s only to be expected given the subject matter at hand. (Case H, issuer) These comments support the proposition (P3c) that accurate ratings need to incorporate the universe of information available to the analytic staff within the CRA and not externally verifiable ones that could be audited by a regulator. However, the subjective nature of a ratings assessment can also be source of frustration for issuers, leading to the split decisions identified earlier in this paper. Network effects enjoyed by the three leading CRAs as antecedents of the oligopolistic market for ratings information were identified by only one interviewee: I think they need to have coverage. They need to be able to cover because there aren’t many of them (Case K, investor) Six interviewees mentioned matters concerning communication. These included updating press releases, the CRA keeping the company up-to date on methodology, and CRAs communicating the rationale for ratings changes. Throughout the interviews, treasurers regularly compared CRAs to other financial service providers. For example: Effectively, I see debt investors and banks several times a year individually. I probably only see the rating agency potentially once a year, and occasionally it has even been less frequently than that. All right, if we are not doing anything there is no reason to meet, but I personally think they should at least be looking for an annual meeting as part of their review process, but it doesn’t always happen. They should seek an ongoing contact. That would probably help avoid some of the bigger downgrades. Never had any problems with upgrades (Case B, issuer). However, CRA communications are a complicated business. A distinct feature of ratings information services is that CRAs maintain a dialogue with both issuers and users of ratings information. For example, investors may telephone a CRA to ask about information contained within a credit report. As recipients of non-public information, CRA communications with ratings information users need to be handled extremely sensitively, for example: I expect them to be robust in dealing with investors; I expect them to be able to talk in general terms about how a rating is justified without actually giving away the wonderful deal you are about to do tomorrow (Case L, OIP) In conclusion, it seems relationship issues are significant in determining ratings quality (P3d). The ability of both parties to interact has a bearing on the overall rating, as well as the ability of the CRA to service the rated security adequately.

5. Discussion This paper explored debt market participants’ views relating to the quality of CRAs and ratings quality, examining three broad research questions: i. the demand for ratings from UK issuers of debt finance; ii. how issuers go about commissioning a CRA to rate a debt security; iii. issues relating to ratings quality. These three questions are addressed by twelve propositions derived from the extant economics of auditing literature. Our findings are summarized in Table 3. Perhaps the least surprising finding was that a rating provided a passport to capital markets (P1a). The only exception seemed to be if it was a private issue of debt, when a rating became preferable, rather than necessary, as it would provide the issuer with superior pricing. The strong growth in demand for ratings is indicative investor demand for ratings information. Selecting a credible CRA (or CRAs) signals an issuer’s quality and integrity, reducing information asymmetry between issuers and investors (Millon and Thakor, 1984). Other potential sources of demand were less apparent from our interviews. The use of ratings information by regulators (P2c) or other third parties for decision-making purposes (P1c) did not appear as a primary consideration when seeking a rating for debt, with investor appetite, pricing, and volatility of pricing being uppermost in interviewees’ minds. It seems plausible that issuers themselves may be unaware of how far-reaching the consequences of a published rating may be. It also suggests that many market participants do not view the use of private ratings for public regulatory purposes as a significant


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Table 3 Summary of findings. Proposition

Findings

P1a Issuers seek a credit rating to reduce information asymmetries, thereby reducing their borrowing costs. P1b Investors’ internal policies require a rating as a precursor to investing in debt securities. P1c Being rated makes the issuer more attractive to other trading partners. P1d A rating reduces adverse selection problems, making the rated security more attractive to a wider selection of investors. P2a Larger issuers in public markets will use the largest CRAs with the highest reputation.

Supported.

P2b Larger issuers in public markets will use multiple CRAs when undertaking a rating exercise to provide the market with ratings information of the highest quality. P2c If an institution invests in securities without a suitable credit rating, this may adversely affect a regulator’s assessment of the institution. P2d Larger CRAs are able to offer issuers access to a range of additional resources. P3a The quality of credit ratings reflects the technical competence of the CRA and its analytic staff.

Partially supported. Also issuers’ internal policies may require them to seek a rating. Not supported. Supported. Supported. Use of larger CRAs not restricted to larger issuers. Supported. Issuers also seek multiple ratings to adjudicate split decision, and use specialist CRAs. Not supported. Not supported. Supported. Consistent methodology, transparency, internal processes within the CRA also identified. Supported. Supported.

P3b The CRA must be independent of issuers and investors to issue high quality credit ratings. P3c A rating should incorporate the professional judgment of the credit analyst, beyond a decision derived from the application of a mechanistic methodology. Supported. Quality of relational exchange between P3d The quality of credit ratings is determined by the quality of the relationship between the issuer and the CRA, i.e., the ability of the issuer and analyst to freely exchange information. issuer and analyst, emphasized by issuers

conflict of interest, unlike the FER (2008). However, this is likely to reflect our UK sample and the fact that European regulators generally make less use of ratings than their US counterparts (CESR, 2005; Langohr and Langohr, 2008). Some support was found for the proposition (P1b) that demand for ratings is created by investors’ internal policies. Our findings identify that some issuers’ own policies require them to seek a rating when a debt issue is made. Among investors, the adverse risk selection hypothesis (P1d) was supported reflecting the heterogeneous nature of the investment community with investors having access to different levels of information and analytic resources. In all cases, issuers used only the three major CRAs (P2a). It would seem that in the UK, there is less demand from issuers and investors for the smaller, specialized CRAs. In general, issuers maintained two ratings. However, this was not standard, with two issuers maintaining a relationship with just one CRA, and three issuers managing relationships with three CRAs. The use of varying numbers of CRAs, presumably each with different qualities, implies there is a heterogeneous demand for ratings services (P2b). This heterogeneous demand implies different levels of ratings quality (cf., DeAngelo, 1981). Consequently, the holding of multiple CRA relationships gives rise to ratings information of higher quality, relative to those issuers with just one CRA. This proposal is also supported by the finding that the non-public debt issuer used just one CRA as nonpublic debt markets required less ratings information, implying less demand for ratings quality. The differential nature of ratings quality is also supported by each CRAs belief that their credit assessment matrices and qualitative examination of a debt security’s prospects are different from other agencies. The idea that CRAs might be providers of other resources (ancillary services) did not seem to be a significant source of demand for ratings. However, the finding that investors undertook considerable credit analysis themselves which served as the primary decision tool also supports the adverse selection hypothesis (P1d) that ratings create a more level playing field for investors, which in turn should reduce an issuer’s cost of capital. The business of commissioning a rating usually reflects history. That is, first, the organization’s historical relationship with the CRA; and second, the treasurer’s relationship with the CRA has often developed over many years, perhaps when working for another employer. A key aspect of the issuer-CRA relationship is its enduring nature. Even if the issuer has a dispute with the agency, the CRA will continue to rate the organization on an unsolicited basis. In this sense, the issuer–CRA relationship will transcend personnel in both the issuer’s and CRA’s organizations. One way in which borrowers manage disputes in such instances is to commission a third CRA in the hope that the additional CRA will provide support to the more favourable rating. However, commissioning a third CRA carries the direct costs associated with an additional rating, the management costs associated with ‘educating’ the additional CRA in the issuer’s business, and the costs associated with the risk that the additional rating may not be as supportive as the issuer would wish. Although the ratings process is described as relatively objective, based on an assessment of the probability of timely repayment of principal and interest on a debt security, it is clear that relationships between the issuer’s treasurer and CRA’s lead analyst are important (P3d). What was evident was that comments about CRAs did not generalize to specific CRAs. For example, a negative comment from one issuer about CRA1’s transparency of decision-making would be counterbalanced by another treasurer’s positive experience with the same CRA. In particular, issuers seemed to attach great importance to the analyst’s experience with the issuer and the issuer’s agency. The issues that arose tended to concern the general level of experience of the analyst, their familiarity in rating securities within the issuer’s industry, and how longstanding their relationship was with the issuer. This in part reflected the issuer’s concerns with having to ‘‘educate’’ or ‘‘get the agency up-tospeed’’ in the company’s business, i.e., the costs associated with those induction or socialization processes the CRA analyst required to ‘‘understand the business’’ and produce credible credit reports (P3c).

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Understanding the components of ratings quality was an important aim of this research. Undoubtedly the implicit safeguard of quality, the reputation of the CRA (P3a) has a great bearing on the quality of ratings information. Specifically, interviewees made reference to implicit safeguards when discussing independence issues (P3b) and the possibility of pricing. The joint independence-competence definition of ratings quality borrowed from the audit literature provided only a basic framework to assess the quality of CRA work. In particular, matters relating to the transparency of how a rating was derived, and the perceived slowness of upgrades and swiftness of downgrades were identified by issuers (P3c). Other communication issues related to the regularity of dialogue and the turnover of trusted analysts (P3d). Issues relating to limited transparency and communication seem to be part of the history and culture of CRAs.10 6. Conclusion This paper sets out the results of interview-based research with key stakeholders in the corporate bond rating process. Viewing CRAs as gatekeepers who serve investors and other stakeholders in corporate decision-making, it describes what motivates companies to seek a bond rating, the use of multiple CRAs, and the determinants of the quality of ratings information. These views are, therefore, quantitative work. Prior research considering the ratings industry has tended to focus on quantitative studies using archival evidence of the determinants of ratings and the effects of ratings changes on securities markets. Given the paucity of evidence considering CRAs’ relationship with market participants, our investigation sought to develop additional theory in this neglected area of finance and corporate governance. Arguably the greatest theoretical contribution of this research lies in the conceptualization of ratings quality. Contrary to audit theory, ratings quality is more than just CRA independence and competence. Ratings quality includes the transparency of CRA decision-making, and CRAs’ ability to communicate the meaning of ratings and ratings changes to a wide range of market participants with different levels of knowledge and expertise in credit matters. Furthermore, CRA relationships with issuers and investors are crucial when conceptualizing ratings quality. The ability of the issuer to convey strategic credibility is paramount to their success in achieving a satisfactory rating and their ultimate aim of reducing their cost of capital. Audit research has partly addressed the auditor-auditee dyad (e.g., Beattie et al., 2000; Gibbins et al., 2001; McCracken et al., 2008). However, it is likely relationship issues will be even more significant between CRAs and issuers as ratings are subject to frequent incremental reassessment, resulting in upgrades and downgrades. An auditor’s decision to qualify a set of accounts, by contrast is relatively dramatic. These findings provide some support for the FER’s (2008) recommendations that CRAs should be more accountable or the transparency of their ratings processes. However, FER’s (2008) idea that CRA management should be held accountable for negligent ratings errors is likely to induce defensive ratings by curb their professional judgment and limiting the use of non-public information that provides a significant source of added-value to the ratings process. Finally, the theory developed from our research has two policy-relevant implications. First, the audit quality literature provides a useful lens to view ratings quality and to develop empirical work. Ratings quality is conceived not just in terms of competence and independence (cf., DeAngelo, 1981), but includes wider technical and relationship factors (see also Duff and Einig, in press). CRAs are an important intermediary between issuers and investors. Their proper function reduces the information gap between these two parties, improves corporate governance, allows issuers to issue debt at more competitive pricing, and investors to supply debt capital with a more certain risk profile. Relationship issues require the CRA to possess sophisticated communication skills, transparency in decision-making, credibility, and an ability to foster trust. The role of the ratings industry played in the sub-prime crisis has intensified pressure on CRA to better communicate their methods. The FER’s (2008) desire to create incentives to improve transparency is starting to come about through market pressure. For example, S&P has announced its own Leadership Programme (S&P, 2008) aimed at restoring its profile as a reputational intermediary subsequent to the subprime failure and associated market fallout. Given the current desire to implement formal Europe-wide regulation of CRAs in Europe, we suggest that politicians and regulators seek oversight of CRA outputs, rather than processes. CRA-stakeholder relations are long-standing and sensitive professional relations. Micro-management of the industry is unlikely to improve ratings quality and heavy-handed rulesbased oversight is likely to impair the ability of the CRA to include its professional judgment, highly valued by ratings users. Whether banking and securities regulators should make less use of CRAs’ ratings, as FER (2008) propose, is an open question. A reduction in the use of private ratings might signal a need for public ratings. Government-funded ratings could create moral hazard issues, an unexpected and undesirable situation. Second, CRAs are generally highly regarded by credit market participants. This finding is some ways runs contrary to other commentators and to perceptions generated in the financial press, where the ratings industry has been frequently criticized. When there was a problem with a CRA, it generally related to personnel. The strong growth in the market for ratings, and therefore ratings analysts, coupled with a perception that better qualified staff in CRAs migrate to employment in banks, and other more prestigious institutions, has meant that CRAs face a potential recruitment crisis. The nature of the ratings business is that it cannot easily recruit experienced staff, as internal policies prohibit the involvement of new recruits even at senior levels

10 Sinclair (2005, pp. 33–34) notes ‘‘Moody’s, true to its history of a more conservative and secretive corporate culture, tended to be much less revealing about its ratings criteria than its major rival. as publishing rating criteria that indicate, for example, acceptable financial ratios for particular industries, were thought to potentially to distort expectations among issuers.’’


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in voting on ratings committee decisions. The business of attracting and retaining good quality staff and fill the void created by the departure of seasoned senior analysts is likely to remain a significant challenge for the ratings industry in the future. Acknowledgment The financial assistance of SATER, the research arm of the Institute of Chartered Accountants of Scotland (ICAS) in undertaking this research is gratefully acknowledged. The paper benefits from the comments of two anonymous reviewers and participants at ICAS/Association of Corporate Treasurers’ seminars held at Bloomberg’s in November 2007, Scotland Europa in Brussels, March 2008, and the American Chamber in Luxembourg, May 2008. Finally, special thanks are due to those credit market participants who agreed to be interviewed and without whom this research could not have been undertaken. References Adams, M., Burton, B., Hardwick, P., 2003. The determinants of credit ratings in the United Kingdom Insurance Industry. 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