Skip to main content

The Credit Rating Industry: An Industrial Organization Analysis

  • Chapter

Part of the The New York University Salomon Center Series on Financial Markets and Institutions book series (SALO,volume 9)

Abstract

The June 1999 and January 2001 proposals by the Bank for International Settlements (BIS) Basel Committee on Banking Supervision to include borrowers’ credit ratings in assessments of the adequacy of banks’ capital have heightened general interest in the credit rating industry: Who the industry’s firms are; what they do; how they do it; and what the consequences of their actions are. This paper uses the structure-behavior-performance paradigm of “industrial organization” to shed light on the credit rating industry and to provide a framework for arranging initial observations and developing questions for further analysis.

A striking fact about the structure of the industry in the United States is its persistent fewness of incumbents. There have never been more than five general-purpose bond rating firms; currently there are only three. Network effects—users’ desires for consistency of rating categories across issuers—are surely part of the explanation. But, for the past 26 years, regulatory restrictions (by the Securities and Exchange Commission) on who can be a “nationally recognized statistical rating Organization” (NRSRO) have surely also played a role.

A curious part of the behavior of the rating firms is their coverage and their pricing. Hypotheses to explain this behavior are explored.

Although only limited information on profitability is available, it appears that bond rating is quite profitable. A growing regulatory demand for ratings (for safety-and- soundness regulation by bank regulators, insurance regulators, pension fund regulators, and securities regulators) and a regulatory limitation on supply surely are contributory factors. The BIS proposals, if adopted, will accentuate these trends for the United States and other industrial countries.

There is an alternative to these growing regulatory pressures. It would involve the safety-and-soundness regulators’ becoming more directly involved in regulatory judgments, rather than abdicating these judgments to private sector bond rating firms. The SEC, and its counterparts abroad, could then vacate their roles as the certifier of credit rating firms.

These suggestions do not mean that credit rating firms should be prevented from playing a continuing role in helping issuers and investors pierce the fog of asymmetric information in financial markets. But that role should be determined by the market participants themselves, not by additional regulation that artificially increases demand and restricts supply. The latter is a recipe for shortages, rents, distortions, and stifled innovation. This is not a welcome prospect.

Keywords

  • Financial Market
  • Mutual Fund
  • Pension Fund
  • Credit Rating
  • Default Probability

These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.

This is a preview of subscription content, access via your institution.

Buying options

Chapter
USD   29.95
Price excludes VAT (USA)
  • DOI: 10.1007/978-1-4615-0999-8_3
  • Chapter length: 23 pages
  • Instant PDF download
  • Readable on all devices
  • Own it forever
  • Exclusive offer for individuals only
  • Tax calculation will be finalised during checkout
eBook
USD   139.00
Price excludes VAT (USA)
  • ISBN: 978-1-4615-0999-8
  • Instant PDF download
  • Readable on all devices
  • Own it forever
  • Exclusive offer for individuals only
  • Tax calculation will be finalised during checkout
Softcover Book
USD   179.99
Price excludes VAT (USA)
Hardcover Book
USD   179.99
Price excludes VAT (USA)

Preview

Unable to display preview. Download preview PDF.

Unable to display preview. Download preview PDF.

References

  • Altman, Edward I. and Anthony Saunders, “An Analysis and Critique of the BIS Proposal on Capital Adequacy and Ratings,” Journal of Banking and Finance, 25 (January 2001), pp. 25–46.

    CrossRef  Google Scholar 

  • Bank for International Settlements, Basel Committee on Banking Supervision, “International Convergence of Capital Measurement and Capital Standards,” July 1988.

    Google Scholar 

  • Bank for International Settlements, Basel Committee on Banking Supervision, “A New Capital Adequacy Framework,” Consultative Paper, June 1999.

    Google Scholar 

  • Bank for International Settlements, Basel Committee on Banking Supervision, “Credit Ratings and Complementary Sources of Credit Quality Information,” Working Paper No.3, August 2000.

    Google Scholar 

  • Bank for International Settlements, Basel Committee on Banking Supervision, “Overview of the New Basel Capital Accord,” Consultative Document, January 2001a.

    Google Scholar 

  • Bank for International Settlements, Basel Committee on Banking Supervision, “The Standardised Approach to Credit Risk,” Supporting Document to the New Base Capital Accord, Consultative Document, January 2001b.

    Google Scholar 

  • Benston, George J., “Accounting Numbers and Economic Values,” Antitrust Bulletin, 27 (Spring 1982), pp. 161–215.

    Google Scholar 

  • Calomiris, Charles W and Andrew Powell, “Can Emerging Bank Regulators Establish Credible Discipline? The Case of Argentina, 1992–1999,” Working Paper 7715, National Bureau of Economic Research, May 2000.

    Google Scholar 

  • Cantor, Richard, “Moody”s Investors Service Response to the Consultative Paper Issued by the Basel Committee on Bank Supervision “A New Capital Adequacy Framework,” Journal of Banking and Finance, 25 (January 2001), pp. 171–185.

    CrossRef  Google Scholar 

  • Carlton, Dennis W. and Jeffrey M. Perloff, Modern Industrial Organization, 2nd edition. New York: Harper-Collins, 1994.

    Google Scholar 

  • Cantor, Richard and Frank Packer, “The Credit Rating Industry,” Journal of Fixed Income, 5 (December 1995), pp. 10–34.

    CrossRef  Google Scholar 

  • Dun & Bradstreet Corporation, “Information Sheet: The New D&B Corporation; Moody’s Corporation,” September 20, 2000.

    Google Scholar 

  • Ederington, Louis H., and Jess B. Yawitz, “The Bond Rating Process,” in Edward I. Altman, ed., Handbook of Financial Markets and Institutions, 6th edition. New York: John Wiley & Sons, 1987, pp. 23–1– 23–7.

    Google Scholar 

  • Federal Reserve System and U.S. Department of the Treasury, “The Feasibility and Desirability of Mandatory Subordinated Debt,” December 2000.

    Google Scholar 

  • Figlewski, Stephen and Lawrence J. White, “Orange County: Don’t Blame Derivatives,” Stern Business, 1 (Spring 1995), pp. 30–35.

    Google Scholar 

  • Fisher, Franklin M., “The Misuse of Accounting Rates of Return: Reply,” American Economic Review,74 (June 1984), pp. 509–517.

    Google Scholar 

  • Fisher, Franklin M. and John J. McGowan, “On the Misuse of Accounting Rates of Return to Infer Monopoly Profits,” American Economic Review, 73 (March 1983), pp. 82–97.

    Google Scholar 

  • Fridson, Martin S., “Why Do Bond Rating Agencies Exist?” Extra Credit (Merrill Lynch), November/ December 1999.

    Google Scholar 

  • Griep, Clifford and Michael de Stefano, “Standard & Poor’s Official Response to the Basel Committee’s Proposal,” Journal of Banking and Finance, 25 January 2001), pp. 149–169.

    CrossRef  Google Scholar 

  • Hickman, W Braddock, Corporate Bond Quality and Investor Experience. Princeton, N.J.: Princeton University Press, 1958.

    Google Scholar 

  • Jewell, Jeff and Miles Livingston, “A Comparison of Bond Ratings from Moody’s, S&P and Fitch,” Financial Markets, Institutions, & Instruments, Vol. 8, No.4, August 1999.

    Google Scholar 

  • Jorion, Philippe, Big Bets Gone Bad: Derivatives and Bankruptcy in Orange County. San Diego: Academic Press, 1995..

    Google Scholar 

  • Moody’s Investors Service, Inc., “Letter to the U.S. Securities and Exchange Commission,” December 5, 1994.

    Google Scholar 

  • Moody’s Investors Service, Inc., “Letter to SEC Commissioner Stephen M.H. Wallman,” October 6, 1995.

    Google Scholar 

  • Moody’s Investors Service, Inc., “Letter to the U.S. Securities and Exchange Commission,” March 2, 1998.

    Google Scholar 

  • Moody’s Corporation, Annual Report 2000, March 15, 2001.

    Google Scholar 

  • Partnoy, Frank, “The Siskel and Ebert of Financial Markets: Two Thumbs Down for the Credit Rating Agencies,” Washington University Law Quarterly, 77 No.3 (1999), pp. 619–712.

    Google Scholar 

  • Pindyk, Robert S. and Daniel L. Rubinfeld, Microeconomics, 5th edn. Upper Saddle River, N.J.: Prentice Hall, 2001.

    Google Scholar 

  • Scherer, F.M. and David Ross, Industrial Market Structure and Economic Performance. 3rd ed. Boston: Houghton Mifflin, 1990.

    Google Scholar 

  • Schwarcz, Steven L., “Private Ordering of Public Markets: The Rating Agency Paradox,” University of Illinois Law Review, 2002 (February 2002), forthcoming.

    Google Scholar 

  • Scott, Kenneth, “The Dual Banking System: A Model of Competition in Regulation,” Stanford Law Review,30 (November 1977), pp. 1–50.

    CrossRef  Google Scholar 

  • Simpson, James B., Simpson’s Contemporary Quotations. Boston: Houghton Mifflin, 1988.

    Google Scholar 

  • Standard & Poor’s, “Standard & Poor’s Official Response to the Basel Committee’s Proposal,” December 1999.

    Google Scholar 

  • Sylla, Richard, “A Historical Primer on the Business of Credit Ratings,” presented at the Conference on “The Role of Credit Reporting Systems in the International Economy,” presented at the World Bank, March 1–2,2001 (mimeo).

    Google Scholar 

  • U.S. Department of Justice, Antitrust Division, “Comments of the United States Department of Justice before the Securities and Exchange Commission,” March 6, 1998.

    Google Scholar 

  • White, Lawrence J., The S&L Debacle: Public Policy Lessons for Bank and Thrift Regulation. New York: Oxford University Press, 1991a.

    Google Scholar 

  • White, Lawrence J., “The Value of Market Value Accounting for the Deposit Insurance System,” Journal of Accounting, Auditing, and Finance, 6 (April 1991b), pp. 284–301.

    Google Scholar 

  • White, Lawrence J., “International Regulation of Securities Markets: Competition or Harmonization?” in A. Lo (ed.), The Industrial Organization and Regulation of Securities Markets, Chicago, University of Chicago Press, 1996a, pp. 207–235.

    Google Scholar 

  • White, Lawrence J., “Competition versus Harmonization: An Overview of International Regulation of Financial Services,” in Claude Barfield, ed., International Trade in Financial Services. Washington: American Enterprise Institute, 1996b, pp. 5–48.

    Google Scholar 

  • White, Lawrence J., “Getting a Grip on Capital,” Secondary Mortgage Markets, 15 (July 1998), pp. 1, 54–59.

    Google Scholar 

  • White, Lawrence J., “Bank Regulation in the U.S.: Lessons from the 1980s and 1990s,”Japan and the World Economy, (forthcoming 2001).

    Google Scholar 

  • Wilson, Richard S., Corporate Senior Securities: Analysis and Evaluation of Bonds, Convertibles and Preferreds. Chicago: Probus, 1987.

    Google Scholar 

Download references

Author information

Authors and Affiliations

Authors

Editor information

Editors and Affiliations

Rights and permissions

Reprints and Permissions

Copyright information

© 2002 Springer Science+Business Media New York

About this chapter

Cite this chapter

White, L.J. (2002). The Credit Rating Industry: An Industrial Organization Analysis. In: Levich, R.M., Majnoni, G., Reinhart, C.M. (eds) Ratings, Rating Agencies and the Global Financial System. The New York University Salomon Center Series on Financial Markets and Institutions, vol 9. Springer, Boston, MA. https://doi.org/10.1007/978-1-4615-0999-8_3

Download citation

  • DOI: https://doi.org/10.1007/978-1-4615-0999-8_3

  • Publisher Name: Springer, Boston, MA

  • Print ISBN: 978-1-4613-5344-7

  • Online ISBN: 978-1-4615-0999-8

  • eBook Packages: Springer Book Archive