Annette Heuser on breaking the credit ratings oligopoly

This article was originally published in, May 8, 2014 What’s broken with the system of credit rating agencies at the moment?

Annette Heuser: The issue is that we have, in a key sector of the financial market, an oligopoly that’s formed by the Big Three. That’s Standard & Poor’s, Moody’s and Fitch. And we know that whenever you have only a few players dominating a specific sector, things can go in the wrong direction. And that’s what we’ve seen and are still seeing with the rating agencies. That is even if the policy makers, or regulators, on both sides of the Atlantic have increased the pressure — via regulatory reform — they are still operating as they did before the Euro crisis. Which is in a very opaque way. Which means nobody knows, for instance, how they really do the ratings; which kinds of indicators they use for sovereign ratings.

Sovereign ratings are the highest asset class — financial sector ratings and corporate ratings depend of sovereign ratings. And they’re done in the most step-motherly and non-transparent way. That needs to change, because sovereign ratings affect not only governments, but they affect you and me as taxpayers. Therefore they should be defined as public goods and they should be transparent, available, and accessible for everyone at no cost.

The issue is that we have, in a key sector of the financial market, an oligopoly that’s formed by the Big Three. That’s Standard & Poor’s, Moody’s and Fitch.

Is your problem with them dealing with the sovereign ratings, or with other goods as a whole?
In general there is a problem with the rating agencies sector. And it starts with the issue of payment model. If your company wants a rating, you go to S&P or Moody’s and you pay for your rating. There is a corporate conflict of interest here if you’re paying for your own rating. This is also the case for a lot of sovereign ratings: a lot of countries, poor countries, who need to have a rating in order to have access to the capital markets are paying the rating agencies to get a rating. And it’s totally non-transparent what these companies or countries are paying the rating agencies. So it opens the door to all sorts of bargaining processes that I wouldn’t consider very transparent, honest or fair.

You have a proposed solution. Can you highlight that for us?
We [The Bertelsmann Foundation] are saying that in order to create more competition in the markets, which will force the Big Three to reform, you have to think in different categories and different terms when it comes to creating an alternative player. We have to take a step back and see how we can set up a non-profit rating agency that operates under different rules than the traditional for-profit players that dominate the market.

This isn’t just a big topic for Europe and the US. Emerging economies and developing countries are fed up with the market dominance by the Big Three in the US and they have an equal interest in reforming the market.

If you were to have a non-profit rating agency — that’s based on a sustainable endowment; that would generate interest to finance the operation; that would have a good internal governance structure; that avoids conflict of interest — you can generate ratings that are based on transparency, accountability and open process. Not just financial experts, but the broader public would have access to these ratings.

This isn’t just a big topic for Europe and the US. Emerging economies and developing countries are fed up with the market dominance by the Big Three in the US and they have an equal interest in reforming the market. So our point is also to bring them on board, because the time is over when Europe and the US can tell the rest of the world how these global institutions — that govern the financial world — are organised.

Do you see INCRA [International Non-profit Credit Rating Agency] as the international body for credit ratings, or will it be one of a number of agencies?
We came up with the idea for INCRA at the height of the Euro crisis when European policy makers were calling for setting up a European ratings agency. We said immediately that it doesn’t make any sense. Because when you take a look at the structure of sovereign bonds and the sovereign bonds market worldwide, it’s not Europe that’s usually in the focus, the bond markets are more interesting and more emerging in other regions, such as Latin America or Asia.

These countries have an equal interest and as many question marks as we have about how the Big Three rating agencies are operating. If Europeans are smart, we’ll bring the emerging and developing economies on board and say ‘OK, how can we make the system better and how can we create an institution that’s transparent and based on a new set of indicators — in our case more qualitative indicators — to evaluate sovereign bonds’.

Can you give us more detail on how you propose to fund INCRA?
We have developed this endowment model because we want to have as much freedom as possible as a non profit. With the endowment you would ask players from different sectors — like central banks, pension funds and big investors — to make a contribution of ‘X’ amount of money, making the funding structure of the endowment as diverse as possible. So the more funders you have, the more diversity you have, the more you can eliminate conflict of interest.

So the endowment would sit there indefinitely [and generate interest]. We’ve calculated that we would need around about $400 million to finance INCRA as an international rating agency with offices in Europe, the US, Latin America and Asia. Because at the end of the day, for sovereign risk, you do not need legions of people analysing countries, you need probably 25 to 30 people around the world.

How is the endowment sustained?
This is part of the outreach phase right now. To test the water, so to speak, to find out if there is this desire to set up an alternative. And if we come to the conclusion in a year and half that everybody is still upset about the world of the rating agencies, but the key actors in the market are not willing to put their money where their mouth is, I think that would be very telling.

What would you do then?
Then we would not explore the model further, because then the key market participants are officially outraged, but are not willing to change the system.

How are you planning on getting recognition and authority for the venture?
It’s interesting, because when you look at the last results of the Big Three, they’re doing even better than before the financial crisis. So, I would ask the ask the regulators ‘what have you achieved by adding one layer of regulation after another, other than providing record profits right now for the Big Three?’

So what’s the plan?
As a think tank we’re unusual in that we’ve not only developed this full concept — down to a full business plan — but we’ve also tested the model in six sample ratings, where we rated the United States, Japan, Germany and Brazil. We are right now in a phase where we want to create attention and support for this model and see if there is “appetite” among the key players investing in sovereign bond, which is central banks, big pension firms and big investment firms, in setting up an alternative player. That’s what we’re doing right now.

How are your early ratings coming out, are you seeing a different reflection of the global economy?
Absolutely. Because in our approach for developed countries, like the US and Germany, we weigh the qualitative indicators that we’ve developed — we call them forward-looking indicators — much higher than the macroeconomic indicators, because we are saying it’s much more important to take a look at governance and the government of a country than the macroeconomics.

How does the UK fair in your analysis?
We haven’t rated the UK yet. But there is still strong confirmation from our ratings committee that the UK is still a solid triple-A, because of its amazing macroeconomic fundamentals — in comparison to the rest of the Eurozone, not really Germany, but the others. I’m a political scientist and I have a few question marks when it comes to the referendum [on Europe], which of course is important with respect to sovereign ratings. The fact that you have a referendum is, from my point of view, a cause of insecurity for the key financial players in the City of London and that could trigger a market reaction.

What if the UK pulled out of EU and Scotland secedes, would that be a double whammy?
Of course, I think that would have a catastrophic effect on the economic and financial performance of the UK overall. I don’t think anyone would doubt that, right? Well, probably some people in your country would doubt that! They would say you were better off out, but I would say it would catapult the UK back for decades and it would also cause a lot of insecurity for the City of London, which is the backbone of the financial performance of the UK.

Annette Heuser is executive director of the Bertelsmann Foundation in Washington, DC