The Potential Effect of Diversification within the Leading Credit Rating Agencies
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In a recent Seeking Alpha article, it was suggested that there is an increasing diversification taking place within the two leading credit rating agencies – S&P Global and Moody’s – since the Global Financial Crisis catapulted the agencies into the public spotlight. The article concludes that increasing diversification may be good for the businesses but bad for the concept of ratings (taken from an investor perspective). In this short post, the focus is on the potential implications of such increasing diversification.
Diversification
It is likely a fair summation to say that the credit rating agencies have been actively diversifying since the Global Financial Crisis. The sentiment here is that the leading agencies understood their fragility after settling for record amounts with (US) governmental bodies and responded accordingly. In actual fact, as I revealed in my PhD Thesis, the reality is that this diversification in product offering and focus began long before the Global Financial Crisis; the agencies took inspiration from the Audit industry and picked up the baton that the auditors had so spectacularly dropped. There is a strong argument to suggest that such diversification helped fuel the Global Financial Crisis, rather than appearing afterwards.
Nevertheless, the diversification cited in the Seeking Alpha article is illustrated in the financial statements of the two credit rating powerhouses. For S&P Global, rating revenue constitutes 30.8% of its overall revenue, whereas for Moody’s rating revenue constitutes 54%:
The Form 10-K of both companies show very different stories, though both are massively intertwined when it comes to their trading history, market dominance, and other metrics. S&P Global is clearly the bigger operator and derives its revenues from a variety of sources. For Moody’s, it is a different story but even within such a concentrated organisation it is clear to see that the tipping point of ratings becoming a secondary source of revenue is fast approaching. That point, for S&P Global, has long since passed. The question for this short post is what may be the implications of this diversification?
Implications
The Seeking Alpha article suggests that ‘a basic premise to begin with is that nothing is as good as ratings. Diversifying away from ratings is therefore an exercise in “deworsification”, as Peter Lynch would call it’. There is a natural constraint on this understanding in that S&P’s index business has an even higher margin than the ratings business which, in itself, already boasts one of the highest margins around. Yet, for S&P Global, according to the Seeking Alpha, the company cannot have it all. Investments into non-ratings businesses will natural deplete the margins within the ratings business, which is why operating margins for the ratings business of Moody’s is far higher (48%) than it is for S&P Global (39%) where ratings is concerned.
There are a variety of implications from these results. For the agencies themselves, this increasing diversification makes them stronger. It protects them from the harsh winds of the financial environments within which they operate. It also protects them from regulatory or legislative reactions to their involvement in the various markets that they contribute to. Equally, it further consolidates their structural roles as financial gatekeepers. Now, increasingly, they not only provide the ratings that the financial system structurally relies upon but they also provide the supportive data and strategic assistance that many financial players require. This further increases the agencies’ strength and prospects.
However, from a structural perspective the diversification is problematic. As we saw with the Audit industry in the lead up to the Enron scandal, and the credit rating agencies in the lead up to the Global Financial Crisis, the provision of consultancy/ancillary services brings with it the increased potential for transgressive behaviour. The increasing potential for conflicts on interests is not positive in such a structurally-important gatekeeper. It also presents challenges for regulators who, traditionally, have only ever utilised financial penalties for discipline. If the targets for regulatory action are increasingly a. richer and b. more diversified in terms of their revenues, the potential disciplinary power that regulators have is naturally reduced. Considering that reality in relation to a financial gatekeeper should ring alarm bells.
For the agencies themselves, it may well soon be the case that the two leading credit rating agencies derive the majority of their revenues from non-rating business. There are a variety of potential issues with this reality, ranging from a lack of incentive to properly resource the ‘cash-cow’, to advancing the ratings business to secure non-ratings business. There is also the theoretical risk that credit rating agencies could discipline market participants with credit ratings to secure long-term non-rating business, or that market participants recognise this dynamic and utilise that knowledge to gain higher ratings. Such behaviours were alleged during the lead up to the Global Financial Crisis.
Ultimately, the credit rating landscape is evolving every day and this coming tipping point for the duopoly that controls the credit rating marketplace will be impactful. In what way we are yet to see, but the potential for that impact to be substantial is significant.
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