May 2012

Rating Sovereign Raters

Credit Rating Agencies - Political Scapegoats or Misguided Messengers?

2

Acknowledgements

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of public policy and corporate responsibility practices to help create

more sustainable societies.’

Infrangilis is part think-tank and part consultancy. We are a values-

driven enterprise based in the UK, and we work globally with multi-

lateral agencies, the public sector, businesses, NGOs and

academia to instigate or accelerate innovative solutions on the

interface between the green economy and sustainable urban

development.

And the story to our name? Infrangilis is based on the Latin word

for ‘unbreakable’. We believe that empowering people to identify

and utilise key leverage points in complex systems – economic,

social and environmental – is the primary route to a resilient planet.

It is important to thank a number of people who have contributed to this report. First, thank you to the

author Philip Monaghan and Eve Sadler who supported the writing and editing process (Infrangilis).

For funding the research thanks go to Kerry McQuade and the staff and trustees at the Andrew

Wainwright Reform Trust. For feeding back on the draft paper thanks go to the following reviewers:

Professor John Ryan (London School of Economics), Ugo Panizza (UNCTAD – United Nations

Conference on Trade and Development), and Michael Lloyd (LCA Europe). Thanks also to others

who have helped shape the wider project or shared their networks, namely: Ha-Joon Chang

(University of Cambridge), Neal Lawson and Joe Cox (Compass), Lydia Prieg (New Economics

Foundation), and Charlotte Steel and Raj Thamotheram (Network for Sustainable Financial Markets).

Disclaimer: feedback from the reviewers or other contributors does not constitute any liability on their

part for the content of this paper. Any errors or omissions in the opinions expressed in this the paper

rest with the author.

© Infrangilis 2012

The contents of this report may be freely used or reproduced without permission provided the source

is stated and the original meaning and context are not altered in any way.

mailto:enquiries@infrangilis.orghttp://www.infrangilis.org/

3

Contents

Acknowledgements 2

Executive summary 4

The dilemma: key statistics and quotes 7

1. Introduction 9

2. The credit rating of nations: the story so far 11

2.1 What are CRAs and why are they so powerful? 11

2.2 Pantomime villain or key perpetrator in the global financial crisis? 11

3. Regulatory context 17

3.1 Regulation before the 2007/08 financial crisis 17

3.2 New regulation in response to the latest crisis 18

3.3 Do resources deployed match the bold talk on CRA scrutiny? 19

3.4 Future regulation? 20

4. Rating the raters 21

4.1 Methodology 21

4.2 Key findings 23

4.3 Analysis of the ratings 30

5. Conclusions and policy recommendations 32

Bibliography 37

4

Executive summary

Holding the credit rating agencies to account

Rating Sovereign Raters is an international study comparing and contrasting the performance of

Credit Rating Agencies (CRAs) to assess their rater worthiness and fitness to rate countries.

The study is intended to contribute to public debate and policy development on supervision of the

ratings industry following the controversy surrounding the credit downgrading of the USA and

additional warnings to the UK, as its economy falls into a double dip recession, about the potential

future loss of its coveted AAA status.

The research looks at issues ranging from competition, transparency and conflicts of interest through

to capital flows to developing countries, competencies and reform of the whole CRA system. Each of

the CRAs analysed is rated according to their performance with regard to responsible leadership,

good governance, public disclosure, and ratings performance. The CRAs are rated between AAA (the

‘gold standard’) and D (worthless), just like the countries they grade, to show whether they are fit for

purpose.

This research is kindly supported by the Andrew Wainwright Reform Trust.

This study is a continuation of Infrangilis’ (a think-tank on resiliency strategies) ongoing work on

responsible capitalism.

Failing to make the grade

Rating the raters concludes that none of the CRAs were able to meet the AA- to AAA gold standard.

Rater ratings

On this evidence, there is a

negative outlook for the

industry as a whole, in terms

of it being fit for purpose. All

seven CRAs analysed have

been found wanting in several

key areas (see the table

opposite).

Although other CRAs are often

overlooked, the ‘big 3’

(Moody’s, Standard and

CRA Rater rating Outlook

Dagong Global Credit Rating BB- Negative

Moody’s Investors Service BB- Negative

Fitch Ratings B+ Negative

Standard & Poor’s Ratings Service B+ Negative

Dominion Bond Rating Service (DBRS) B- Negative

Japanese Credit Rating Agency (JCR) CCC+ Negative

Ratings & Investment Information (R&I) CCC- Negative

5

Poor’s and Fitch) do not necessarily perform the best either, with Standard and Poor’s and Fitch doing

less well than one of the smaller rating agencies (Dagong).

Whilst there are weak results across the board, poor performance is particularly acute in relation to

the aspects of ‘responsible leadership’ and ‘ratings performance’ (see the figure below).

CRA performance by aspect

0

5

10

15

20

25Responsible leadership

Good governance

Public disclosure

Ratings performance

CRA average

Gold standard (AA- to AAA+)

In terms of responsible leadership, this appears to be because the CRAs have a narrow

understanding about the impact of their actions (for instance failing not only to appreciate their role in

partly causing the financially unstable climate but also failing to understand other non-financial

problems too – for example environmental resource constraints or poverty).

These findings are further supported by the damning verdicts on ratings performance that 6 of these 7

CRAs received in annual checks made by both the US (SEC) and European (ESMA) regulators.

Watching the watchers

This research also concludes that deployment of resources may not always match the bold talk on

CRA supervision.

Freedom of Information (FOI) applications by Infrangilis to a number of national and international

supervisory authorities revealed, for instance, at the European regulator ESMA just 13 staff (from a

6

total of 75 people) are dedicated to dealing with the CRA industry across the whole of the Eurozone,

with only €150,000 allocated to onsite CRA investigations (which is less than the €161,000 allocated

to postage and telecommunications, and a fraction of ESMA’s €20.3 million annual budget).

To put these numbers in further context, the EU employs 33,033 people and has a total budget of

€147.2 billion. So the question becomes, is this an appropriate allocation of EC resources to CRA

scrutiny given the Eurozone bailout fund is €734 billion? Given, particularly, that it is alleged the

financial meltdown was precipitated in part by a failure of the CRAs to identify and warn the markets

about the Greek collapse and US sub prime mortgages?

The transition to a resilient approach on sovereign debt

Infrangilis recommends a number of key policy changes to remodel the rating of sovereign debt that

will make the system resilient to future shocks and more productive. The study calls for:

A return to the CRAs serving the public interest

‘Rewiring’ regulation to reduce the importance of the CRA industry

The right kind of competition amongst CRAs

Up-skilling the CRA workforce

More effective co-operation between governments on CRA supervision

Political leaders to provide better stewardship of CRA supervision and wider industry reform.

Infrangilis will share these ideas with key supervisory bodies including ESMA and SEC; policy makers

involved in the G20 Summit in Mexico; the House of Commons Treasury Select Committee (which is

currently hearing evidence about the conduct of the CRAs); and key players associated with the

Conference on Sustainable Development in Brazil (Rio+20).

If you also believe how important reviewing the CRAs role is, we would love to hear from you at

ratingsovereignraters@infrangilis.org. You can tweet us @Infrangilis_ltd or get involved with the

debate at #ratingsovereignraters. The more people who know about this and realise how vital the

reform of the CRA industry is, the quicker we can influence change.

7

The dilemma: key statistics and quotes

“They've handled themselves very poorly. And they've shown a stunning lack of knowledge

about the basic U.S. fiscal budget math”

Timothy Geithner, US Treasury Secretary (commenting after Standard and Poor’s downgraded

America’s AAA status in August 2011) (Crutsinger, 2011).

“Moody’s performance in 2011, a tumultuous year for financial markets, built impressively on

the strong gains we made in 2010. Our products and services reached a record number of

customers in both developed and emerging markets.”

Raymond, W. McDaniel, Jr, Chairman and CEO, Moody’s (Moody’s Corporation, 2012).

"I know that we are taking a political gamble to set this up as a measure of success... but

judge us by whether we can protect the UK credit rating."

George Osborne, shadow UK Chancellor, 2010 (before the 2010 general election which his

Conservative Party won) (Thomson, 2012).

$41 trillion

$930 billion

The value of sovereign debt in 2011 (up 11.8% on the previous

year). This is equivalent to 69% of global GDP and is up from 58%

since the financial crisis began in 2007/8) (Roxburgh et al, 2011).

Ceiling for Eurozone bailout fund (Strupczewski, 2012) –

precipitated in part it is alleged by the failure of the rating agencies

to identify and warn the markets about a Greek collapse or US sub

prime mortgages (Henry, 2011; Younglei & da Costa, 2011).

CRA global market share

Moody's (40%)

S&P (40%)

Fitch (15%)

Others (5%)

The combined market share

of the industry’s ‘big 3’

players – Moody’s,

Standard and Poor’s and

Fitch (House of Lords,

2011).

95%

Growth in Moody’s annual revenue in 2011 from previous year to $2.3 billion - the

highest in the company’s history. In addition, net income increased by $64 million

(13%) to $571 million (Moody’s, 2012).

12%

8

“The operational rigour of the CRAs is… in question. Standard & Poor’s caused the latest

controversy with its erroneous downgrade of France. The agency’s email went out November

10, 2011, just before 4pm Paris time when the European markets were still open. It’s ‘opinion’

thrust a knife into ‘containment’. S&P waited two hours to issue a correction after the

European markets had closed.”

Professor John Ryan, London School of Economics (Ryan, 2012a).

“We have identified a number of shortcomings and it is very important that they are

addressed.”

Steven Maijoor, Chairman, European Securities and Markets Authority (commenting on the EU

regulator’s onsite examination of the supervision of CRAs which warned that Rating Committees were

failing to record their votes and reasons considered) (Masters, 2012).

0 + 0 = 0

4

€150,000

0.039%

Total number of staff plus total budget the Bank of England dedicates

to dealing with the CRA industry. (Bank of England, 2012 - freedom of

information response to Infrangilis).

Total number of meetings held between the Bank of England’s

Governor, Deputy Governors or Executive Directors and industry

representatives during 2011 (at a time when the UK was in recession

and warned about a possible future sovereign downgrade) (Bank of

England, 2012 - freedom of information response to Infrangilis).

The EU regulator (ESMA) budget allocation for CRA inspections in 2012

(less than the €161,000 set aside for postage and telecommunications).

Just 13 from 33,033 staff at the European Commission are dedicated to

supervising rating agencies (ESMA, 2012a - freedom of information

response to Infrangilis).

Proportion of registered rating agencies examined by the US regulator that failed to

follow their ratings procedures in some instances in 2011 in terms of conducting

business in accordance with policies and methodologies (SEC, 2011).

100%

-6

-7

6 out of the 7 CRAs assessed do not reference a whistle-blowing procedure in their

public documentation (e.g. annual report or website).

None of the 7 CRAs assessed made reference with regard to measurement of the non-

financial impacts of their products in their publication documentation (e.g. annual report

of website) (Infrangilis, 2012).

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1. Introduction

“The are two superpowers in the world today in my opinion. There’s the United States and there’s

Moody’s Bond Rating Service. The United States can destroy you by dropping bombs, and Moody’s

can destroy you by downgrading your bonds. And believe me, it’s not clear sometimes who’s more

powerful.”

Thomas Friedman, Journalist, 1996 (credit: Partnoy, 1999)

As it stands today, government debt is a huge (and growing) trillion-dollar global industry. One in

which private firms called credit rating agencies (CRAs) have long flourished during times of

economic uncertainty or adversity. They continue to do so.

Yet, how has it come to pass that these rating agencies, which were once held in high regard for their

innovation in financial services and for providing a valuable service to investors, are now regarded

with such revulsion? Does it really matter? And if it does matter, what can be done about it?

CRAs have been a pivotal player in the global economic system for over a century and date back to

the financing of the US railroad expansion in 1909. However, it took the international banking

meltdown of 2007/08 to thrust them into the public consciousness and into media prominence. In

2011, the lingering economic recession led these firms to downgrade the credit rating of G8 nations

including the USA, France, Italy and Spain (based upon assessments of their austerity plans and/or

growth strategies) and issue warnings to others including the UK on the possibility of a future

downgrade. This created hysteria amongst the media, public and politicians, with leaders of these

and other mature economies reacting with what can only be described as fury, fear or relief

depending on the result.

But why the hysteria associated with the G8 downgrades? Well, one resulting worry of a country

being downgraded is that it can lead to a vicious economic circle. Concerns surround the potential

rise in the annual interest bill not only having to be met by struggling taxpayers, but also that it could

undermine consumer and investor confidence and thus result in a double-dip recession and an even

larger fiscal deficit. If a sovereign downgrade happens to Greece or Ireland then perhaps these are

isolated incidences that do not hurt the rest of the world (so one argument goes). But if it could

happen to a super power like the USA, it could happen to anybody and harm everybody.

The dramatic events of the past 5 years and the huge power of the CRAs have thus led many

commentators to ask whether they are friend or foe. And if they are the latter, what should be done to

tackle this powerful industry?

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Yet, proposals to reform or replace the role of the CRAs has been fractured and piecemeal, with

political leaders and campaigners tending to focus on single issues - ranging from competition and

conflicts of interest; through to analyst competencies and capital flows to developing countries.

Infrangilis strongly believes that policy interventions to regulate the CRA industry would be better

developed by a greater understanding of the complex system in which government borrowing and

debt ratings take place – i.e. the interconnectedness of financial systems. This means we need to

understand the historical context that shaped the emergence of the CRAs and then consider carefully

what future role (if any) they should play in the global financial system. To this end, this study is

intended to highlight the synergies and conflicts in decision making across a number of these single

issues by comparing and contrasting the performance of the industry. It includes an examination of

the practices of firms such as: Moody’s (USA), Standard and Poor’s (USA), Fitch (UK/USA), Dominion

Bond Rating Service (Canada), Japanese Credit Rating Agency (Japan), Ratings and Investment

Information (Japan), and Dagong Global Credit Rating (China). The report concludes with a number

of policy recommendations for corrective action in the context of current regulatory proposals in the

Eurozone, the USA, the UN and beyond. The upside of the current crisis is that it provides a crucial

window of opportunity that will not return for another generation, so it is important we get any reform

of the industry right.

As a think-tank that focuses on resiliency strategies,

Infrangilis’ underpinning conviction for this study is that self-

determination for communities is the key to vibrant nations,

and that we cannot achieve local sustainability unless we fail

to solve certain trans-national problems. One such example

would be communitarian forms of finance (like credit unions).

These can be undermined by inaccurate rating downgrades,

which, in turn, hurts the poor the most and weakens the

diversity of the financial ecosystem, thus making it more

homogenous and vulnerable to future banking collapses.

(Themes explored in more detail in section 2.2)

This study draws and builds upon Infrangilis’ earlier work on

Sustainability in Austerity (November 2010) and How Local

Resilience Creates Sustainable Societies (February 2012).

11

2. The credit rating of nations: the story so far

"I know that we are taking a political gamble to set this up as a measure of success... but judge us by

whether we can protect the UK credit rating."

George Osborne, shadow UK Chancellor, 2010 (before the 2010 general election which his

Conservative Party won) (Thomson, 2012).

2.1 What are CRAs and why are they so powerful?

CRAs assess the worthiness of individuals, organisations (e.g. companies, financial institutions, local

governments) and/or countries to borrow money. This independent analysis is intended to help

investors to make comparisons and inform decisions about where best to invest their money.

For nations, this borrowing is a form of debt known as bonds. In this case, sovereign credit raters

assign credit ratings for issuers of debt. The rating takes into account their ability to pay back its loan.

This, in turn, affects the interest rate applied to the bond being issued (as investors demand a higher

rate of return the riskier debt) and, ultimately, makes it more or less expensive for a country to borrow

money (Martson, 2011). Most CRAs make a distinction between investment grade (low-risk) and

speculative grade (higher-risk) ratings, with the top rating being ‘AAA’ (meaning a very safe

investment) and the bottom rating being ‘D’ (meaning in default or bankruptcy). The CRAs generate

revenue through an ‘issuer-pays’ model, by which the borrowing entity pays the rater to rate their

debt. These CRAs also produce ‘unsolicited’ ratings, that is, ratings that are not requested by the

rated entity, and which include sovereigns (House of Lords, 2011).

The origin of the CRAs dates back to the independent bond rating initiated by John Moody in the USA

in 1909 (Sylla, 2001). This was specifically in relation to debt incurred to fund the huge railroad

programme. At the turn of the twentieth century, increasing demands from investors and financial

regulators for greater disclosure of corporate operational and financial information led to the transfer

of investment banker’s reputation role as a certifier of the quality of bonds to the CRA. At the time, the

introduction of credit rating was lauded as a process innovation that would allow the country to

develop responsibly and led to rapid growth of the CRA industry between 1909 and 1930. As a result,

by this time the US regulators were incorporating CRA ratings into their regulations.

Post war prosperity and stability meant that by the 1960s, however, the agencies had become

relatively unimportant. The US bond market was too safe for them to matter much. Mostly a US

phenomenon up until this point, the rest of the world provided only marginal business for the industry.

The CRAs only expanded rapidly again during the 1970s as the Bretton Woods System collapsed and

a new era of financial globalisation emerged. The liberalisation of capital flows and redistribution of

OPEC wealth resulted in a far greater number of sovereign states, as well as private corporations,

12

issuing bonds. This dramatic change meant people once again sought independent certifications of

investment security and quality. A key difference this time around, however, was that the agencies

shifted the main way they generated revenue from charging investors (by subscribing for information)

to charging issuers of securities (by imposing a fee for each transaction by the debtor), which, in turn,

raised questions about what those who pay receive in return. This resurgence in their importance

even led to the US Securities and Exchange Commission (SEC) in 1973 to designate certain CRAs

as Nationally Recognised Statistical Ratings Organisations (NRSROs). At the time this designation

raised a concern that the use of CRAs for regulatory purposes was an abdication of duty by the

government, as it put these private agencies into the business of selling regulatory licenses. Despite

this concern, the number of rated bonds increased markedly over the next three decades. In 1975

there were 5,500 rated corporate bonds, but by 2000 Moody’s had rated 21,200 public and private,

which amounted to $2 trillion worth of securities (Sylla, 2001).

The 2007/08 financial crisis halted an expansion of global capital that had lasted for the previous

three decades, but in the subsequent two years it resumed and with global public debt rising fast

(Roxburgh et al, 2011). In 2011, sovereign debt was valued at $41 trillion (up 11.8% on the previous

year) and equivalent to 69% of global GDP (up from 58% since the crisis began). To put this further in

context, Moody’s annual revenue grew by 12% in 2011 on the previous year’s revenue to $2.3 billion -

the highest in the company’s history. Net income also increased by $64 million (13%) to $571 million

(Moody’s, 2012).

Figure 1: CRA global market share

By 2011 there were also reportedly

some 76 rating agencies around the

world (House of Lords, 2011), and the

market dominated by three big Anglo-

American firms: Moody’s Investors

Service (USA), Standard & Poor’s

Ratings Services (USA) and Fitch

Ratings (UK/USA). (Market share is

depicted in Figure 1).

However, whilst the smaller CRAs tended to focus on niche or regional markets, there are important

notable exceptions with long established sovereign credit rating functions - including Dominion Bond

Rating Service (Canada), Ratings & Investment Information Service (Japan) and the Japanese Credit

Rating Agency (Japan) - all of who have a global sphere of influence. Dagong (China’s leading CRA)

had also begun to rate sovereign debt too – a further indication of the eastern super power’s wealth

and how it had emerged onto the global market.

Moody's (40%)

S&P (40%)

Fitch (15%)

Others (5%)

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Whilst media focus to date has been on the practices of the big 3 which control 95% of market share -

Moody’s and Standard and Poor’s each have about 40%, whilst third-ranked Fitch has about 15% - it

is important to look at the practices of others too. Sovereign credit ratings are not confined to the

practices of the Anglo-American companies. It should also be remembered that not only are Japan

and China the largest foreign creditors; but, in the case of China, its influence is also expected to

grow over time (due to it’s large surpluses that fund this debt market) (Roxburgh et al, 2011). A profile

of these CRAs is depicted in Table 1 (note: statistics refer to the entire organisation and not just the

sovereign ratings function).

Table 1: CRA profiles

CRA Global

headquarters

Parent firm/

Major shareholder

Market

share

Total

staff

Annual

revenue

Moody’s Investors

Service

USA Berkshire

Hathaway

~40% 6,126 $2.3 billion

Standard & Poor’s

Ratings Service

USA McGraw-Hill ~40% 6,300 $1.8 billion

Fitch Ratings

UK/USA Fimalac, S.A. &

Hearst Corp

~15% 2,000 $668.4 million

Dominion Bond Rating

Service (DBRS)

Canada -

14

2007/08 banking crisis, or the subsequent Eurozone crisis of the past two years are just the latest

examples. The 1997 Asian financial bubble and the 2001 Enron scandal are other disastrous

miscalculations stretching over decades (Henry, 2011; Younglei & da Costa, 2011). For instance,

CRAs gave AAA ratings to 75% of the $3.2 trillion sub-prime mortgages that subsequently lost sizable

valuable just months later (Bai, 2010). A lack of competition amongst the CRAs is cited as one major

factor for this poor performance – that is, an oligopoly led by the big 3 encourages complacency and

drives down sector quality.

Perhaps more seriously, it is argued bad performance by the CRAs may not always be down to

human error, but rather to conflicts of interest. Testimony to the SEC points to the use by Moody’s of

a long-standing culture of intimidation and harassment to persuade its analysts to ensure ratings

match those desired by the company’s clients (Neate, 2011). But more than this, it also argued that

the CRAs routinely favour banks and corporations that pay them more than nations do. That is, bonds

from countries that pay half as much as issuers of less creditworthy debt are rated more harshly

(Detrixhe, 2011).

Similarly, it is argued that other public institutions like municipals get a raw deal too - with states such

as California paying more to borrow than companies like Caterpillar Inc., yet which have the same or

lower credit ratings and typically default at 86 times the municipal rate (Money News, 2012). The

dramatic irony is, of course, that it was the collapse of banks and companies that had been rated

favourably by the CRAs that triggered the crisis in the first place! This left governments (and cities)

having to borrow to fund the ensuing bailouts and recovery plans. Worse still, these ‘rating triggers’

(correct and erroneous alike) are self-reinforcing according to the London School of Economics’

banking expert Professor John Ryan, whereby they create a downward spiral in which sovereigns

struggle to raise capital to invest in growth, to repay debt and restore their credit worthiness (Ryan,

2012a; Ryan 2012b).

Others concur but say not only are the CRAs inaccurate and have inherent conflicts of interest; it is

alleged they also bully governments around the world, citing the case of the state legislators of

Georgia in the US (Chakrabortty, 2012). In 2003, before the sub prime problem, Georgia brought in

tough new laws to limit predatory lending, but says Chakrabortty (2012) when Standard & Poor’s said

it would no longer rate mortgage-backed bonds in Georgia as a result of this, the law was repealed.

Whilst allegations of incompetence, conflicts of interest or irresponsible lobbying have dominated the

critiques of the CRAs, other substantive concerns have also been expressed about how this industry

undermines wider developmental goals too. That is, the industry’s current objectives are so far

removed from its founding purpose (which was to facilitate responsible investment and growth), that it

no longer performs a public good.

15

Most striking is the claim that CRAs are undeservedly preventing the flow of capital into the developed

world, arguably because the industry tends not devote time and resources to economies such as

Africa because it is not a lucrative market (bearing in mind their funding model of ‘issuer-pays’). This

means dozens of developing countries find it more difficult to raise money to grow as they are do not

have a credit rating, or as was the case in Mali, the rating is out of date and does not recognise any

positive progress made by a country. As such, this seriously undermines efforts to meet the UN

Millennium Development Goals (Prieg, 2011; Elkhoury, 2008).

Additionally it is argued these negative impacts on development are felt in developed countries as

well as developing countries (Monaghan, 2012). So, for instance, communitarian forms of finance like

credit unions in Canada, UK, USA and elsewhere could be hit hard by the ripple effect of rating

downgrades in terms of their savings being diminished by poor market performance or the cost of

borrowing going up (Shannon, 2011). This will not only hurt the poor the most, undermining efforts by

local communities to regenerate, but it also weakens the diversity of the financial ecosystem and thus

makes nations with homogenous banking systems further vulnerable to future collapses (Elliott,

2011).

Furthermore, it is also argued that CRAs are measuring the wrong things (i.e. traditional financial

performance) anyhow when it comes to determining credit worthiness. Longer-term, sustainability

factors are more accurate in predicting credit worthiness on the basis that a country’s solvency

depends on its future tax receipts (Willem van Gelder et al, 2011; Zadek, 2011). Consequently, a case

has been made for CRAs to move beyond solely financial measures to count in social and

environmental externalities – good for prudent economic management, good for social progress and

good for protecting the planet alike.

Case for the defence

A number of policy makers and leading experts also argue, however, that whilst the industry may

have it shortcomings, this does not mean the CRAs are primarily to blame for the current turmoil.

A report by the UK House of Lords concludes that despite the CRAs’ failure to spot the warning signs

in the run up to the 2007/08 banking crisis or the industry operating as an oligopoly (which they do

highlight needs to be addressed); much of the criticism levied at the industry in the wake of current

Eurozone crisis is unwarranted. And, is in effect, a case of ‘shooting the messenger’. It the end,

argues the report, investors are too often guilty of blindly following the CRAs, as opposed to viewing

them as opinions that need to be balanced against other market indicators (House of Lords, 2011).

Finance Watch (Hache, 2012) and the Black Sea Trade and Development Bank (Gavras, 2012) point

out that whilst concerns over poor performance and/or conflicts of interest are valid, they miss the

most important problem, that the CRAs - are private firms which have become ‘hardwired’ into the

public regulatory system. For, as Hache (2012) and Gavras (2012) point out, this is something which

16

they were not designed to do and any failure here is actually on the part of the regulators, as the

ratings assessments were originally intended for private financial markets only. That is, measuring the

credit-worthiness of private issuers is fundamentally different from rating sovereign debt. (E.g. for

corporate bonds, default probabilities can be estimated quite ‘mechanically’ from cash flow projections

for instance. But for sovereigns, the appetite for various forms of default - from currency debasement

through rescheduling to non-payment - is more qualitative, including more macro modeling and

‘judgments’ on the interaction of cultural and political factors). Furthermore, as private firms, the

CRAs’ aims are to maximise profit and shareholder value and not to promote stability or prosperity.

Due to weak licensing, CRAs are selected because of market recognition, not according to their

performance.

In the case of the Eurozone problems, Cambridge economist Ha-Joon Chang goes further and points

out that Europe is strangling itself with a toxic mixture of austerity, as well as a structurally flawed

financial system (Chang, 2012). He argues that instead of the EU policy makers focusing on

draconian spending cuts and regulation that increases competition and transparency in the CRA

industry, they would be wiser if they followed the USA which has focused on growth and moved to

make the regulatory system less dependent on the CRAs. But Chang also adds that both the USA

and Europe would do even better if they simplified the entire financial system so that the world was

less reliant on CRAs to assess the risk associated with financial transactions in the modern complex

system.

Whilst supporting many of Chang’s proposals, OpenDemocracy concludes that is ‘we’, the public, that

are ultimately at fault (Curzon Price, 2012) as we provide the social guarantee that allows finance to

function properly. So, if governments do not take responsibility for what is prudent and what is not,

and instead outsource this responsibility to rating agencies, it is the electorate that are to blame for

not holding politicians to account.

So, in summarising the case for and against the CRAs, it seems no one disputes that either debt-

rating is important to prudent economic management, or that there is an over reliance on the rating

agencies. Rather, the contention is in relation to how best to reform the CRA industry and govern the

wider system of sovereign debt.

To determine what kinds of reforms might be necessary it is helpful to understand how the rules of the

game have evolved pre and post the 2007/08 financial crisis and how successful today’s supervision

actually is. This is explored in chapter 3.

17

3. Regulatory context

“… Conflict of interest permeates all levels of levels of employment from entry-level analyst to the

chairman and chief executive officer of Moody’s corporation”

William Harrington, former Senior President, Moody’s, 2011 (in a filing to the US Securities and

Exchange Commission) (Neate, 2011)

3.1 Regulation before the 2007/08 financial crisis

Despite European and US reliance on private firms for independent debt-ratings over the past four

decades, there has been limited imposed supervision of the CRA industry across the Atlantic or

indeed the rest of the world. Rather than government licensing or regulatory requirements, CRAs

have adopted voluntary codes. This has led to a concern that the industry has unaccountable power.

A prime example of this concern is that regulatory policy means the CRAs are mostly exempt from

legal standards and, therefore, not liable for litigation that may result from inaccurate rating

assessments (Katz et al, 2009). For instance, in the USA it is claimed that the CRAs ‘hide behind’ the

First Amendment (i.e. freedom of speech) (Ryan, 2012a), with their defence being that they cannot be

held accountable as the assessments are merely the sharing of their ‘opinion’. However, whilst

litigation has occasionally occurred, there is a lack of judicial precedent which has resulted in lawsuits

being dismissed by courts and settled on favourable terms to the CRAs (Partnoy, 2009).

Below is an overview of the regulatory environment at the time of the crisis.

Internationally

The International Organization of Securities Commission’s (IOSCO) Statement of Principles

Regarding the Activities of Credit Rating Agencies (2003) and Code of Conduct Fundamentals for

Credit Rating Agencies (2004) stipulate voluntary principles for CRAs. These are based on a ‘comply

or explain’ basis, whereby the onus is on the CRAs to adopt them as a matter of course. IOSCO is a

global body that aims to develop international standards on regulation of securities markets to protect

investors and is part of the powerful Joint Forum (see Box 1). IOSCO voluntary principles relate to

four categories: i) quality and integrity of the rating process, ii) independence and avoidance of

conflicts of interest, iii) responsibilities to the investing public and issuers, and iv) public disclosure of

their own code of conduct (IOSCO, 2012; Gavras, 2012; Sy, 2009).

Box 1: Supervising the supervisors

The Joint forum is a cross-sector group established between IOSCO, the Bank for International

Settlements (BIS) and the International Association of Insurance Supervisors (IAIS). BIS works with

18

central banks in the pursuit of monetary and financial stability (e.g. Basel Accords on cross-border

capital flows). IAIS represents insurance regulators and supervisors to deal with issues common to

the banking, securities and insurance sectors (including the regulation of financial conglomerates).

Eurozone

The European Union has tended to prefer voluntary adherence to this IOSCO code (Katz et al, 2009).

In addition, the EU Capital Requirements Directive (2000) allowed CRAs recognised by national

authorities to provide assessments of risk when calculating the minimum capital requirements of

banks. Although, the EU Markets Abuse Directive (2003) and Markets in Financial Instruments

Directive (2004) excluded CRAs from the definition of investment recommendations.

USA

The SEC began the informal process of recognising rating agencies in 1975, by designating them as

NRSROs. This allowed regulated entities such as banks to select an agency to perform a rating to

meet regulatory obligations. Following corporate scandals like Enron, the Credit Rating Agency

Reform Act came into force in 2006 and placed new requirements on these agencies. This included

the need for agencies wishing to be treated as NRSROs to be registered, for them to disclose their

internal standards and rating methodology and report on performance periodically. Whilst the Act also

allowed the SEC to conduct on-site inspections and prosecute for any breaches of the law, it did not

however allow the SEC to regulate on the methodologies used by the rating agencies.

3.2 New regulation in response to the latest crisis

Internationally

The IOSCO responded to the 2007/08 financial crisis by updating its 2004 Code of Conduct in 2008

(this included the timeliness of ratings, and a review of compensations policies etc) and proposed that

this code was used as a template for the supervision of CRAs. The G20’s decision to establish a

Financial Stability Board in 2009 to promote financial stability provided further impetus to the call for a

greater understanding of the impact of CRAs (The Joint Forum, 2009).

Eurozone

Since 2009 all CRAs operating in the EU need to register with the Committee of European Securities

Regulators (CESR) to be supervised by its successor organisation the European Securities Markets

Authority (ESMA) and the home member state. These CRAs are subject to new legally binding rules

that are based on the revised IOSCO code. The EU strategy also includes proposals for issuers of

debt to have to rotate rating agencies every 1 to 3 years for certain financial products, for the EU

regulator to have greater control over the publication of sovereign debt ratings, and discussions for

the establishment of a EU rating agency.

19

USA

Around the same time, SEC also enhanced its regulation of CRAs through The Dodd-Frank Act 2010,

which included changes such as the establishment of professional standards for training CRA

analysts. The key difference however between this Act and the response of the EU was that it

required US regulators to explore ways to reduce their reliance on CRAs (Gavras, 2012; Katz et al,

2009).

The positions of the Eurozone and the US are not clearly demarked however. European member

states are not united in their support for the EU regulatory proposals. The UK’s position, for instance,

is much closer to that of the USA. In 2011, reports by the EU Committee of the UK House of Lords

and the Bank of England concluded that whilst the global CRA industry is an oligopoly that would

benefit from greater competition, it argued against the creation of a publicly funded European rating

agency and instead called for less reliance by investors on sovereign ratings (House of Lords, 2011;

Deb et al, 2011).

3.3 Do resources deployed match the bold talk on CRA scrutiny?

So, how well are these revised arrangements to engage the CRA industry in a more robust way

working out in practice?

Infrangilis made Freedom of Information (FOI) applications to a number of national and international

supervisory authorities to shed light on a possible void between government strategy and practical

implementation when it comes to supervision of the CRAs. The FOI requests were made on 18 April

2012 and mainly related to business meetings between public bodies and the industry, the resources

deployed by public bodies to deal with the industry over the past 1-5 years, and complaints received

about the industry in terms of conflicts of interest and inaccurate or incompetent performance.

The UK responses provided interesting food for thought::

HM Treasury declined to provide information on business meetings between Ministers and

senior civil servants on the topic of the UK’s sovereign rating (on the grounds it was not in the

public interest) or the amount of resources dedicated to dealing with the industry (on the

grounds the amount was so small it would enable identification of the salary of specific

individuals which would amount to the release of personal data which would be a breach of

the Data Protection Act) (HM Treasury, 2012). But HM Treasury’s FOI response did confirm

that in the past year the equivalent of just 2.75 full time equivalent (FTE) officials performed

work associated with the CRA industry (HM Treasury has an annual budget of £200 million

and employs 1,377 FTE staff in total (HM Treasury, 2011)).

The Bank of England’s FOI response was more revealing (Bank of England, 2012). A search

of diary records for the past year showed that the Governor, Deputy Governors and the

Executive Directors for Monetary Analysis, Financial Stability and Markets met only 4 times

20

with any of the seven leading CRAs evaluated in this study; and that the amount of staff and

resources dedicated to dealing with the industry was zero. (The Bank of England has an

annual budget of £278.4 million and employs 1,839 full-time/part-time staff in total (Bank of

England, 2011)).

Yet, a key plank of the Bank of England’s mission as mandated by HM Treasury is to stand at the

centre of the UK's financial system to promote and maintain financial stability by identifying

systemic threats including from financial infrastructure, regulatory policies and international

events. So, given that the UK is in recession and was being warned by the CRA industry that its

sovereign rating may be downgraded in the future – a clear and present danger to UK financial

stability – why has such meagre resource and time been invested in this area by these bodies so

they and the Financial Services Authority can coordinate supervision efforts with ESMA and work

collaboratively with IOSCO and SEC? Surely something is amiss in terms of risk management by

the Bank of England’s and Treasury’s leadership teams given the fact that whether they like it or

not the CRAs are still ‘hard wired’ into the UK regulatory system? Especially so, given the

Chancellor (as head of HM Treasury) George Osborne has staked his party’s reputation on

retaining the UK’s AAA credit rating (Thomson, 2012).

ESMA’s FOI response was equally revealing:

Just ESMA 13 staff (from a total of 75 people) is dedicated to dealing with the CRA industry

across the whole of the Eurozone.

Only €150,000 is allocated to onsite CRA investigations (which is less than the €161,000

allocated to postage and telecommunications, and a fraction of ESMA’s €20.3 million annual

budget) (ESMA, 2012a).

To put these numbers in further context, the EC employs 33,033 people and has a total budget of

€147.2 billion. So the question becomes, is this an appropriate allocation of EC resources to CRA

scrutiny given the Eurozone bailout fund is €734 billion (Strupczewski, 2012)? Given, particularly, that

it is alleged the financial meltdown was precipitated in part by a failure of the CRAs to identify and

warn the markets about the Greek collapse and US sub prime mortgages?

Note: In terms of other FOI submissions made it should be observed that: the UK Financial Services

Authority refused to reply to most of Infrangilis’ questions on cost grounds (but did say that part of one

of the questions might be answered if a further FOI submission was made) (FSA, 2012). Infrangilis

also received a response from the European Central Bank however it simply referred Infrangilis to

published policy frameworks without answering the questions posed (ECB, 2012). Infrangilis was also

sent a response by the EC Directorate-General for Economic and Affairs saying the application was

being handled but that it was unable to comply within the required time limit of 15 working days

(ECFIN, 2012).

21

3.4 Future regulation?

Despite the significant proposed changes to CRA regulation in the US and EU over past two years,

further change is on the horizon in 2012. Most notably, details of how to implement the Basel III

framework and the European Commission’s proposal to establish a European rating agency are yet to

be agreed, if at all.

In the UK, the House of Commons Treasury Select Committee is currently hearing evidence about the

conduct of the CRAs. The role of CRAs in financial stability and sustainable development will be also

be an agenda item when world leaders gather at the next G20 summit in Mexico and UN Conference

on Sustainable Development (Rio+20) during June.

As such, Infrangilis strongly believes that the year 2012 represents a once in a generation opportunity

to get things right when it comes to how the world rates creditworthiness. Yet, it seems proposals to

reform or replace the role of the sovereign credit raters remains fractured and piecemeal, with political

leaders and campaigners tending to focus on single issues - ranging from transparency and conflicts

of interest through to capital flows to developing countries and non-financial competencies.

This is where a rating of the sovereign credit raters becomes invaluable if we are to hold the CRA

industry to account and ensure it continues to serve the public interest.

4. Rating the raters

“Don’t blame the ratings agencies for the Eurozone turmoil… Europe and the Eurozone are strangling

themselves with a toxic mixture of austerity and a structurally flawed financial system.”

Ha-Joon Chang, Reader, Faculty of Economics, University of Cambridge, 2012 (Chang, 2012).

4.1 Methodology

Assessment criteria for ratings

Infrangilis’ evaluation of sovereign credit raters focuses on four key aspects: i) responsible leadership,

ii) good governance, iii) public disclosure, and iv) ratings performance. The four aspects are equally

weighted. CRAs are assessed against a number of questions for each of these aspects (as detailed in

Table 1).

22

Table 2: Assessment questions

Aspect Questions to be answered

Resp

on

sib

le le

ad

ers

hip

Does the CRA understand the critical issues associated with its business strategy and

products on sovereign debt rating? (i.e. with regard to economic, social and

environmental measures)

To what extent is the CRA a leader in working to address challenges and concerns

across the ratings industry? (i.e. going beyond the mandatory minimum, product

innovation)

Does the CRA promote a corporate culture that supports positive change within the firm

and the industry? (i.e. company values, corporate social responsibility programmes)

Go

od

go

vern

an

ce

Does the CRA demonstrate how its board and senior management are governing

effectively? (i.e. avoiding conflicts of interest or anti-competition, prohibiting coercive

practices, delivering quality ratings, third party assessment)

To what extent is the CRA developing staff and system competencies to deliver against

business strategy and industry codes? (i.e. review of remuneration policies, professional

standards and training, whistle-blowing and grievance procedures, analytical resources

and IT systems)

Is there evidence that the CRA is working to identify and manage the key non-financial

impacts associated with its operations? (i.e. the sustainability of its products and

services, access to products and services in the developing world)

Pu

blic d

isclo

su

re

Does the CRA explain how it is compliant with regulatory disclosure requirements in all

its areas of operation? (i.e. adherence to US Dodd-Frank and/or EU ESMA standards

etc)

To what extent does the CRA explain how it consults and responds to other key

stakeholders? (i.e. engaging with investor bodies, civil society, the media etc)

Does the CRA disclose how it is responsibly lobbying for change in the ratings industry?

(i.e. publishing policy positions, disclosing Ministerial meetings, releasing details of

sponsorship/donations, disclosing the contracting of professional lobbyists)

Rati

ng

s p

erf

orm

an

ce

Does the CRA provide open and free access to its ratings methodology and

performance? (i.e. methodology criteria and assumptions, previous year’s performance,

regulator statements on performance)

Is there evidence that the CRA is satisfying regulators or key stakeholders in the

accuracy and competency of its ratings? (i.e. positive results from onsite checks by

supervisory bodies, positive customer feedback, positive media coverage)

Does the CRA measure the non-financial impacts of its performance and how it is

addressing any negative impacts? (i.e. financial stability, economic growth, anti-poverty,

climate change adaptation).

23

Following assessment and resulting score given against each of the criteria, the CRAs are then given

an overall rating on their ‘rater worthiness’, based on a sliding scale from AAA (the ‘gold standard’) to

D (worthless), just like the countries they grade (as show in Table 2). Only a rating of AA- to AAA is

deemed a ‘positive outlook’ and considered an acceptable quality standard for a CRA, with a rating

from D to BBB- deemed a ‘negative outlook’.

Table 3: Scoring the raters

Rater rating Score Meaning Outlook

AA- to AAA 76-100 The gold standard, a quality leader Positive

BBB- to A+ 51-75 Only moderately safe, some weaknesses and can do more Negative

B- to BB+ 26-50 Risk concerns, evidence of repeated failings

D to CCC+ 0-25 Major trust worry, lack of convincing information about quality

Data source and external review process

Findings are compiled by assessing information collated during 2011/12 from: data that CRAs

released into the public domain (annual reports and website disclosures), government statements

(freedom of information applications made by Infrangilis and official regulator public reports e.g. SEC,

ESMA), media coverage (e.g. Bloomberg, Financial Times, The Economist) and other stakeholder

opinions (public debate through an open roundtable discussion organised with Infrangilis).

In addition, a number of experts – drawn from senior figures in the investor community,

intergovernmental institutions, academia and civil society scrutinised/shaped Infrangilis’ findings and

conclusions.

CRAs that were awarded a rating

The rating is applied to a select group of sovereign credit raters from across the world, namely:

Moody’s (USA), Standard & Poor’s (USA), Fitch (UK/USA), DBRS (Canada), JCR (Japan), R&I

(Japan), and Dagong (China). This sample group of seven represents about 10% of all firms

operating in the industry (it is estimated there are 76 in total), however, collectively they account for

the vast majority of market share.

Whilst media focus to date has been on the practices of the big 3 which control 95% of market share -

Moody’s and Standard & Poor’s each have about 40%, whilst third-ranked Fitch has about 15% - it is

important to look at the practices of others too. Disputes over sovereign credit ratings are not confined

to the practices of the Anglo-American companies. It should also be remembered that not only are

countries like Japan and China the largest foreign creditors, but in the case of China with its large

surpluses this market influence is expected to grow over time (Roxburgh et al, 2011). That is, it is

important to appreciate the direction of travel.

24

Infrangilis recognises that these ratings should be taken as indicative of a CRAs performance as

opposed to definitive. We recognise that there are some limitations to the methodology - some CRAs

may be less accustomed to public disclosure than others; annual reports look at a past point in time

and current performance may be different; media coverage of an issue may not always be balanced;

and freedom of information responses may be constrained for legal limitations or other reasons. As

such, Infrangilis welcomes feedback from the CRA community and other stakeholders on this study at

ratingsovereignraters@infrangilis.org.

Conflicts of interest

Infrangilis does not have relationships of a commercial or personal nature with any of the CRAs

evaluated.

4.2 Key findings

An overview - the ‘magnificent 7’?

The table below lists the ‘rater worthiness’ for each of the CRAs in descending order of grade (note:

where the grade is equal the CRAs are listed alphabetically).

Table 4: Rater ratings

None of the firms were able to meet the AA- to AAA gold standard. On this evidence, there is a

negative outlook for the industry as a whole in terms of it being fit for purpose, with all seven CRAs

having been found wanting in several key areas. The big 3 do not necessarily perform the best either,

with Standard and Poor’s and Fitch doing less well than one of the smaller rating agencies (Dagong).

Figure 2 shows how the industry performs against each aspect (by taking the average scores). Whilst

there are weak results across the board, poor performance is particularly acute in terms of

‘responsible leadership’ and ‘ratings performance’. Specifically with regard to responsible leadership,

this appears to be because the CRAs have a narrow understanding about the impact of their actions

CRA Rater rating Outlook

Dagong Global Credit Rating BB- Negative

Moody’s Investors Service BB- Negative

Fitch Ratings B+ Negative

Standard & Poor’s Ratings Service B+ Negative

Dominion Bond Rating Service (DBRS) B- Negative

Japanese Credit Rating Agency (JCR) CCC+ Negative

Ratings & Investment Information (R&I) CCC- Negative

25

(for instance failing not only to appreciate their role in partly causing financial instability but also failing

to understand other non-financial problems too). Regarding ratings performance, the most notable

shortcoming is that the majority (6 of the 7 agencies) have received damning verdicts in annual

checks made by both the US (SEC) and European (ESMA) regulators.

Figure 2: CRA performance by aspect

0

5

10

15

20

25

Responsible leadership

Good governance

Public disclosure

Ratings performance

CRA average

Gold standard (AA- to AAA+)

The report cards below provide a summary of the strengths and areas of weaknesses of each the

seven CRAs on the basis of the Infrangilis evaluation (they appear in alphabetical order).

Figure 3: CRA report cards

Dagong [BB-]

Outspoken critic of industry oligopoly and supporter of supra sovereign

rater (e.g. published articles such as ‘Rating agencies need large scale

reform’ and ‘Financial reform needs risk ratings to go first’).

'Company Culture' section of website talks at length about emphasis on

impartiality and professional training.

Commitment to innovation includes establishing China’s first Post-doctoral

research station in the rating industry to provide leading risk assessment

technology and research services for capital market and founding China’s

first credit rating and risk management training school, Dagong Credit

Management School (jointly with Tianjin University of Finance and

Economics).

No mention of public filings on corporate governance and ratings

disclosure to Chinese, Mongolian or other sovereign authorities (i.e. ‘Rating

certifications' web page only says where it is allowed to trade) (It does

however disclose its rating approach in ‘Procedures and methodologies’).

No indication of whistle-blowing policy being in place so staff can report

any wrongdoing.

No mention of how it is measuring and managing the non-financial impacts

of its financial products.

Despite the plaudits in some quarters for its campaigning on reform of the

industry, it is unclear how it is responding to any public concerns about its

own performance.

DBRS [B-]

Public filings on corporate governance and ratings disclosure to US and

EU financial regulators easy to access and use.

The document 'Strengthening transparency' in the context of Canadian, US

and EU regulatory reforms on disclosure outlines how it is augmenting its

approaches accordingly.

‘Regulatory affairs' section of website provides openly available list of

correspondence with regulators e.g. one entitled 'DBRS response to EMSA

call for evidence’.

Annual checks by US regulator conclude it failed to follow rating

procedures in some instances.

No indication of whistle-blowing policy being in place so staff can report

any wrongdoing.

No mention of how it is measuring and managing the non-financial impacts

of its financial products.

Document 'DBRS response to proposed rules for NRSROs’ calls some of

the US reforms harsh on a cost basis without balancing it with public

concerns over need for change.

27

Fitch [B+]

Public filings on corporate governance and ratings disclosure to US and

EU financial regulators easy to access and use.

Its joint owner Fimalac discloses the fact that Fitch Ratings is currently

involved in a number of federal and state civil litigations in connection with

bonds issued by municipalities and other public entities.

'CEO message' section of website acknowledges that the credit and

financial crises have put increased emphasis on the value of transparency

and the annual report talks about how it is investing to respond to this.

Annual checks by US and EU financial regulators conclude it failed to

follow rating procedures in some instances and not devoting sufficient

resources to internal controls.

No indication of whistle-blowing policy being in place so staff can report

any wrongdoing.

Commitments by (joint) parent company Fimalac through its 'environmental

report' and 'culture and diversity foundation' only deal with estates

environmental controls and philanthropic giving and do not appear to factor in

the non-financial impacts of its products.

'Comments on the European Commission's proposal' is a position

statement on regulatory changes that argues against rotation, litigation, and

regulatory approval without balancing this with why people are concerned.

JCR [CCC+]

Public filings on corporate governance and ratings disclosure to US

regulator easy to access and use.

'Rating methodology' acknowledges industry failings and learning from

East Asia currency crisis in 1997.

Reference made to a commitment to establish a whistle-blowing policy so

staff can report any wrongdoing in ‘Application for registration as an NRSRO’

document (although it is not clear if this policy has been implemented or not).

Annual checks by US regulator conclude it failed to follow rating

procedures in some instances.

Public filings on corporate governance ratings disclosure to EU regulator is

unclear.

No mention of how it is responding to public concerns about the industry.

No mention of how it is measuring and managing the non-financial impacts

of its financial products.

28

Moody’s [BB-]

Public filings on corporate governance and ratings disclosure to US and

EU financial regulators easy to access and use.

Public statement of support for less regulatory reliance on ratings and

more competition.

Special report ‘A solution for the CRA debate’ acknowledges support for

public sector sovereign rater.

Annual checks by US and EU financial regulators conclude it failed to

follow rating procedures in some instances and not devote sufficient

resources to internal controls.

No indication of whistle-blowing policy being in place so staff can report

any wrongdoing.

Commitments to Corporate Social Responsibility and Environmental Policy

do not appear to factor in the non-financial impacts of its products.

Says ‘Weekly Credit Outlook’ is effort to create value for all users, but it is

unclear how this responds to more serious public concerns e.g. liability

protection (Moody’s talks about the danger of government intrusion into

freedom of opinion).

R&I [CCC-]

'Regulatory affairs' section of website details relationships e.g. withdrawal

from US as a NSRSO and ‘Code of Conduct’ refers to regulatory regimes in

Japan versus IOSCO principles.

The document 'Policy management capacity - the key to evaluating

sovereign credit worthiness' attempts to highlight a solution to the debt crisis

and its position.

Annual checks by US regulators conclude it failed to follow rating

procedures in some instances.

Public filings on corporate governance and ratings disclosure to EU

financial regulator is unclear.

No indication of whistle-blowing policy being in place so staff can report

any wrongdoing.

No mention of how it is responding to public concerns about the industry

No mention of how it or its parent company Nikkei Group is measuring and

managing the non-financial impacts of its financial products.

29

Standard & Poor [B+]

Public filings on corporate governance and ratings disclosure to US and

EU financial regulators easy to access and use.

Upgrading of governance and staff quality e.g. enhancing analytical

training by introducing a new Analytical Certification Program which all

analysts must pass in order to act as a primary analyst on a rating or to vote

in a rating committee.

'Leadership Actions' section of website aims to shows how it is attempting

to increase transparency and respond to recommendations by constituencies

such as Interfaith Center for Corporate Responsibility.

Annual checks by US and EU financial regulators conclude it failed to

follow rating procedures in some instances and not devoting sufficient

resources to internal controls.

No indication of whistle-blowing policy being in place so staff can report

any wrongdoing.

No mention of how it or its parent company McGraw-Hill is measuring and

managing the non-financial impacts of its financial products.

‘The role and regulation of rating agencies in Europe’ is a position

statement that argues against rotation, litigation, regulatory involvement and

shareholder restrictions - but does not acknowledge public challenges to this.

Despite this sad display overall, there are some promising signs too. The industry is not homogenous

in how it is responding to calls for more accountability, with some appearing to be doing more than

others to win back or grow their reputation capital. Dagong for instance is outspoken about the need

to overhaul the current oligopoly. This compares favourably with others like R&I, which does not even

acknowledge any public concern about the sector.

4.3 Analysis of the ratings

A number of the key points raised by the rating cards are detailed below.

Ratings roulette

A major insight from this rating of the CRAs is an apparent lack of standardisation in analytical

methodologies, inconsistency with which these are applied and a variety of levels of disclosure as to

the assumptions and information sources that underpin the opinions. This finding was supported by

the one of biggest and most withering critiques of the CRAs from the US regulator in late 2011.

Examinations conducted by SEC staff (of all seven CRAs with the exception of Dagong) concluded

that in terms of going about their business in accordance with policies, procedures and methodologies

all ‘failed to follow their ratings procedures in some instances’ (SEC, 2011:13). Infrangilis’ analysis of

the CRAs’ disclosed methodologies also shows both a lack of common language and varying levels of

depth of detail, which would make it difficult for users to contrast quality. Moody’s, for instance, could

be seen as relatively weaker with regard to how underlying assumptions attached to its high level

rating criteria correlate to its grading – i.e. economic resiliency and government financial robustness.

By comparison, DBRS’ guidelines are clearer in how a particular rating is calculated for each criterion.

A case in point is assessments on economic performance, whereby it appears judgements on

sovereign austerity plans in the Eurozone are being made without CRAs being clear what constitutes

a robust austerity plan (i.e. in terms of focus, scale and pace).

Controls fiasco

Shortcomings in the approach of the big 3’s internal controls are further highlighted in annual checks

by the EU regulator. Following onsite investigations in late 2011, ESMA concluded that ‘parts of the

CRA’s internal processes (i.e. Rating Committees and other key internal meetings) were not

‘sufficiently recorded’’ (ESMA, 2012b: 7). That is, whilst the CRAs had in place rating committees as

required by law, these committees were failing to record their votes and the reasons considered. In

addition, the committees were not being given enough time to prepare for their meetings (due to the

timing of the distribution of documents in advance of the meetings).

Furthermore, in relation to management conflicts of interest or reporting wrongdoing, Infrangilis’

review of published materials such as industry Codes of Conduct only identified a single reference to

in-house procedures on ‘whistle-blowing’ that would allow CRAs analysts to report any wrongdoing

31

without fear of retribution. This was by JCR – in its application for registration as an NRSRO it made a

commitment to establish a whistle-blowing system as part of internal controls to ensure compliance

with its Code Conduct (however it is unclear whether this has been implemented or not).

Ignoring the problem of public dissatisfaction

Another major finding of the study is the questionable ability of the CRA industry to satisfy regulators

and other key stakeholders in the accuracy or competency of its ratings, be it errors in relation to

sovereign ratings for France, the USA or elsewhere. In addition to the failings reported by SEC and

ESMA following their onsite examinations, there has also been substantial and sustained (mostly

negative) public critiques made by academics, civil society and media alike – ranging from the

Financial Times to Forbes magazine (see for instance Crutsinger (2011), Detrixhe (2011), and Henry

(2011)).

Infrangilis’ rating of the raters shows that some CRAs do however appear to be making some attempt

to acknowledge this public concern and show how they are listening and responding, even if they say

they disagree with the public sentiment. (Examples here include all of the big 3 – not surprising given

they tend to be the focus of most of the media barrages against the CRA industry). Yet others fail to

do even this, most notably R&I, which bizarrely makes no reference to the problem.

Missing the big picture

Assessment of the CRAs’ public commitments to Corporate Social Responsibility (CSR) or Corporate

Environmental Policies (CEP) (by the parent companies of Moody’s, Fitch and R&I) by Infrangilis

shows these are confined to issues related to environmental controls for corporate estates, staff

volunteering and community philanthropy. These are fine as far as they go, but the biggest footprint

issue for the industry is its products, not its premises (which is what robust CSR/CEP commitments

often do). Yet, no apparent mention is made of the developmental, social or environmental impacts of

CRAs’ financial products. (Just as crucially, neither the US or EU regulators reference these bigger

picture issues either. A point returned to in chapter 5).

Fresh thinking

Despite the serious problems identified by Infrangilis’ rating, there is some promising news too. Not all

the firms are the same, despite them sharing the same industry brand and being ‘tarred with the brush

of failure’. Some are going beyond the mandatory minimum or sector norm.

Dagong in particular should be applauded for its campaigning on wholesale industrial reform. It has

been credited for instance with supporting a call for a supra sovereign organisation that would ‘blend’

independence, justice, innovation and fairness (El Namaki, 2012). To a much lesser extent, the new

public policy position of Moody’s should not go unnoticed either – despite nearly a century enjoying

the fruits of its oligopoly position it appears to have broken ranks with the rest of the big 3 and is

supportive of calls for rotation. Only time will tell if its actions match these bold words.

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5. Conclusions and policy recommendations

“They've handled themselves very poorly. And they've shown a stunning lack of knowledge about the

basic U.S. fiscal budget math”

Timothy Geithner, US Treasury Secretary (commenting after Standard & Poor downgraded America’s

AAA status in August 2011) (Crutsinger, 2011).

Based on the findings from the rating of the CRAs, Infrangilis reflects on the evidence examined and

puts forward a number of policy proposals to remodel the rating of sovereign debt. The intention here

is that not only should it become more resilient to future shocks, but also that it is more productive.

Infrangilis will share these ideas with key supervisory bodies such as ESMA and SEC, policy makers

involved with the G20 Summit in Mexico and the House of Commons Treasury Select Committee, and

organisers of the Conference on Sustainable Development in Brazil (Rio+20). If you also believe how

important reviewing the CRAs role is, please share your thoughts at

ratingsovereignraters@infrangilis.org, tweet us @Infrangilis_ltd or get involved with the debate at

#ratingsovereignraters. The more people who know about this and realise how important reform of the

CRA industry, the quicker we can influence change.

A return to serving in the public interest

At times over the past half decade, CRAs have become a parody of themselves; they have

unaccountable power that has seen their influence grow as their performance dips. Not surprisingly

then the recent ‘witch hunt’ of these private firms highlights the need for the industry to rediscover its

original and previously hard won reputation for offering a quality product that serves society well (i.e.

its origins in the development of the US railroads).

To make this happen a fundamental change in what citizens or politicians expect of CRAs is required.

Instead of relinquishing responsibility to other institutions, we all have a personal responsibility to

ensure the capital markets function properly. Most importantly it requires reducing our reliance on

CRAs (alternatives are discussed below). There should also be a burden of proof on the industry as to

how CRAs continue to add value in a modern and complex world. Access to capital should not be the

end goal, but rather a route to the real objectives: stability, resilience and prosperity for developed and

developing countries alike.

Similar to wider market reform proposals (Gore and Blood, 2011; van Gelder et al, 2011) the industry

should be held to account for the ramifications of its opinions over the longer-term. New US and EU

regulation to counter anti-competition, conflicts of interest or poor performance do not go far enough.

Policy makers must re-write the rulebook on credit worthiness so that it takes into consideration wider

social development and environmental risk factors in a fair and balanced way. The type of principles

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encapsulated by universally agreed sustainable development goals such as the UN Global Compact.

Including, for instance, a requirement that all UN countries have an up to date credit rating.

Rewiring regulation

We need to fast track the reversal of years of ‘hard wiring’ CRAs into regulatory systems. Professor

Frank Partnoy at the Center on Corporate and Securities Law (Partnoy, 2009) has argued

convincingly that there are a variety of alternative measures that may be used to evaluate credit risk

and supplement or even replace CRAs (e.g. investors might revise their guidelines to reflect a

blended standard of information sources used to make investment decisions). Indeed, argues

Partnoy, over the longer term institutional investors are likely to welcome a regulatory move away

from rating agencies as the lack of accountability in the industry undermines market performance. At

the same time, he cautions that the current way of doing business cannot be unwoven easily given

that mandates to use ratings have become part of the fabric of financial markets. Hence a mix of

policy responses is required to ensure a ‘soft landing’ during any transition. Thus, as well as removing

protection from litigation, there needs to be full transparency of sovereign credit rater methodologies

including full disclosure of all underlying assumptions attached to their assessment tools.

Yet whilst Partnoy’s points are well made, surely what is also needed is convergence on the

methodology used and a public record of any erroneous calculations in the use of the assessment

tools? This would allow investors and debtors to operate on a level playing field. It would also provide

the evidence base for reasonable litigation.

The right kind of competition

Efforts to break up the oligopoly by making it easer for appropriate new players to enter the market or

forcing debtors to rotate their choice of CRA are well intentioned, and should in principle be

welcomed. (See for instance the INCRA blueprint in Box 2). However, it should be noted that more

choice could have its downsides too though: opportunities for issuers to shop around might allow

them to mislead trusting investors (Bolton et al, 2011).

Box 2: Process innovation or shifting the deck chairs around on the Titanic?

The Bertelsmann Foundation has proposed a thought-provoking blueprint for establishing a global

non-profit agency for sovereign debt called INCRA (Bertelsmann Foundation, 2012). The idea is to

bring together leading industrialised countries and NGOs to fund and steward an international agency

to rival existing for-profit players. The benefit of this is that it avoids conflicts of interest by making

rating decisions that are independent from its financiers. A compelling case to support this proposal is

that in addition to building a multi-stakeholder governance model, refreshingly, INCRA also proposes

to utilise non-financial indicators to rate sovereigns. These so-called ‘forward looking’ indicators

include social and environmental concerns such as citizen trust in public institutions and resource

efficiency.

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The blueprint says that initially INCRA will have multiple bases in Asia and Latin America as well as

the US and Europe, with ones in Africa and the Middle East possibly following later. However, whilst

this has the merits of moving away from an exclusive Anglo-American model of good governance, it

would appear to still not resolve the plight of many developing countries like Mali who it is claimed are

getting a raw deal from the industry and still will not have a voice at the decision making table.

Another part of the case against this particular proposal is that it may lack legitimacy in many people’s

eyes if it has been co-developed with organisations that are seen as part of the problem, regardless of

intelligence they bring. Former senior staff from Moody’s have helped to craft the INCRA blueprint for

instance. Bizarrely, the 5-year budget for the $400 million also has cost lines for a CEO salary of

about $0.65 million, property rental of between $1.45 million - $2.19 million per annum, plus $1.76

million for recruitment costs - all for a workforce of just 44 – 58. Surely, such apparent luxury does not

fit well with the non-profit ethos of the blueprint? Thus is unlikely to be welcomed by governments or

NGOs at any time, never mind in the midst of what is a recession for many.

Up-skilling the workforce

A new mission for the CRA industry means people who work in these private firms – directors and

analysts alike – have the necessary competencies and attitudes and are supported by appropriate

employment and control procedures. Despite encouraging proposals arising from the US Dodd-Frank

Act to re-skill analysts, being simply competent in financial accounting or in industrial economics is no

longer sufficient. Broader expertise in environmental science and social policy is also essential. It is

also vital that analysts are drawn from the countries they rate – be it Africa, Asia or Latin America – so

they better understand the regional context.

Such up-skilling needs to be backed up by a new ethical code, whereby irresponsible lobbying,

coercive practices or conflicts of interest become a thing of the past. A ‘carrot and stick’ approach is

recommended here. Regulators should require by law that all registered debt raters have a whistle

blowing procedure (against which they should report on, like other controls).

Enabling this to happen also requires rethinking how staff performance relates to remuneration.

Learning from other sectors, such as the short-term outlook of vulture capitalists or the abuse of

accounting for barrels of oil in the petroleum market, shows there must never be an incentive not to

pursue long-term value creation.

Trans-governmental cooperation, not border walls

Calls to establish a supra-sovereign ratings organisation, be it a new EU or UN led one have not been

welcomed by the UK and US governments in particular. Arguments against these proposals include a

lack of appetite to grow public sector architecture, the tax burden associated with the high cost of set-

up, that regional structures would create further confusion in a global marketplace, a perceived lack of

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market legitimacy (e.g. conflicts of interest if any EU rating agency were to rate Eurobonds), and that

it is not clear how this would reduce dependency on the industry (as well undo its hard wiring into

regulation). For example, various proposals by the Bertelsmann Foundation (the philanthropic arm of

the publisher by the same name) and Roland Berger consultancy to resource a new supra-sovereign

CRA require an endowment of up to $400 million (Mackenzie, 2012). (Box 2 explored the

Bertelsmann proposal in more detail). The counter argument to this indifference is that the benefits

outweigh the downside, given the much greater cost of market failure as a result of the banking crisis

in terms of the world recession that resulted in the huge loss of wealth, jobs and prosperity.

Perhaps then an accommodating position or hybrid model can be found? Key is that is it done at the

international level and by an organisation with expertise and credibility to perform the task (Lloyd,

2011). For instance, by establishing a new UN platform as a credit rating observatory as opposed to a

credit rating service provider. This could be hot-housed by an existing body that has the respect of the

markets, such as The Joint Forum (which, after all is based at BIS whose mission is to act as a centre

for discussion and decision making for the international supervisory community (BIS, 2012)). This

would only have merit, however, if the terms of reference and top leadership of this body were

refreshed to reflect its new mission. Having it led by central bankers or former heads of the big 3

raters would be counter-productive as it would be seen as simply moving the chairs around on the

Titanic! Any newly reconstituted Forum would also need to have the trust and endorsement of the

BRIC countries (Brazil, Russia, India and China) and others parts of the South, a fact reflected in its

governance structure. This additional work by The Joint Forum should aim to avoid the need for

additional public subsidy or a transaction tax. A simplification of the system would realise savings that

could be redirected here, for example, by merging divisions of IAIS, BIS, IOSCO and the IMF or

sharing examiners already at work in SEC and ESMA. In short, to do more with less.

Any such UN observatory should be tasked with i) monitoring and reporting on how well the market is

functioning (e.g. adequate flow of credit to developing countries; as well as SMEs or municipals); ii)

acting as an early warning system (given what a good or bad austerity or growth plan is); iii)

certificating all products (Chang, 2010); iv) securing consensus on international professional

standards for rating methodologies and the analysts that use them (to counter the concern that an

Anglo-American model of governance is being imposed on others); v) developing a single

measurement and reporting framework to compare and contrast ‘rater worthiness’; and vi) investin