A "natural oligopoly" in rating credit?
Two very large companies dominate the credit-rating industry, the familiar names Moody's (formerly part of Dun & Bradstreet) and Standard & Poor's (a division of McGraw-Hill). These two companies own around 80% of the market. A third competitor, Paris-based Fitch Ratings, has a smaller share of the market, around 12%. No other significant major competitors exist, though there are companies that rate local securities in places like China and India.
The ratings industry is expanding rapidly for the three big players. Whenever a company or municipality issues any form of security or bond, they get one or more of the three rating companies to signal the risk involved in making their promised repayments to investors, using the familiar scale that begins with AAA and runs to the "speculative" grade. Each position on the grade helps determine the cost of borrowing for the bond issuer. Once given, ratings are reviewed on an annual basis. And each review is a nail-biter.
But there is a conflict of interest in the system. Companies pay for the "privilege" of being rated, and the fee is negotiable. There are perpetual grumbles about the agencies possibly giving better ratings to the companies that pay higher fees. On the other hand, the rating agencies are attacked for missing out on such imminent collapses as Enron and WorldCom. In an age when we are discovering massive corruption in investment banks, insurance companies, mutual funds, and other financial institutions, the ratings firms are essentially unregulated.
A story in the Economist ("Who rates the raters?". 3/26/2005), takes note of the lack of competition in the industry.
The business functions as an oligopoly. Upstarts have a hard time breaking in because it takes years, even decades, to build a sufficient reputation. "It is difficult for a rating agency to pop up because you need a 20-year track record," said one asset manager.
The article points out that Fitch Ratings, the seeming exception to the rule, is base don a combination of four smaller existing credit rating companies: Fitch, IBCA, BANKWATCH, and Duff & Phelps, all snapped up and merged in the last few years by French conglomerate Fimilac S.A.
Furthermore, the article notes, they only power the Securities and Exchange (Commission (SEC) in the US has is in certifying acceptable rating agencies, making the barrier to entry for upstarts all the higher. The oligopoly has set things up so there is no real price competition between the big three, and their rates have all become very similar. Since major deals require at least two, and better three, ratings, there's plenty of profits for all three companies.
While the industry may be (as the Economist article says) an example of a "natural oligopoly" since adding more raters would make the whole system more complex and less trustworthy, there are big dangers in the current unregulated situation. But the article notes that until some big scandal is uncovered, the big three rating agencies have unchallenged power over the world's financial markets.
