The Existing and Proposed Credit Rating Agency (CRA) Business Models and Compensation Models Are Inefficient

Introduction

The motivation for and context of this chapter are varied. First and unfortunately, the “Big-Three” CRAs (Moodys, Fitch and S&P) now affect the equivalent of more than eighty trillion US dollars of securities, swaps/derivatives and financial instruments globally, and thus have a significant and growing effect on international capital flows. Second, the International Organization of Securities Commissions (IOSCO) and the European Commission, the US Government and many governments have debated and issued statements and proposed regulations for CRAs, most of which have been ineffective. Third, the business models and compensation contracts of CRAs have symbiotic relationship with antitrust violations and the nature of competition and antitrust in the CRA industry. Becker & Milbourn (2011). Thus, there are sufficient grounds for regulating CRAs through competition law; and that various antitrust problems can be solved or reduced by changing the business models and compensation models of CRAs. Fourth, there is a growing consensus in many countries that the big-three CRAs were being used for political and economic-domination purposes. As a result, countries like China and Russia, in their push to de-couple from the US dollar dominated international transactions of 2000-2018, and to ameliorate the effects of Economic Sanctions imposed on them, and to gain more global economic power, have been creating their own CRAs and have developed CRA regulations. Specifically, the number of CRAs in China increased from about one in 2008 to about seventeen in 2015. Given the international scope of investments of Chinese and Japanese government agencies, companies and high-net-worth individuals, that will likely affect many countries. Fifth, the bond markets of many countries like China, Brazil, India, Indonesia and Japan grew significantly during 2005-2020 – as of 2020, the Chinese bond market alone was worth more than US$1.7trillion. The exponential growth of cross-border trade during 1995-2020 has led to increases of the numbers and sizes of companies that often subject to conflicting corporate governance standards and continue to rely on credit ratings as one of several measures of trust. Increasing foreign ownership of shares has also highlighted the importance of corporate governance and credit ratings. Sixth, the Global Financial Crisis has exposed significant weaknesses in economies and Corporate Governance standards in organizations, and strategic decision-making by Boards of Directors (BODs) and has slowed economic growth in both industrialized and developing countries. Both individual and institutional investors around the world are increasingly emphasizing the quality and implementation of corporate governance standards and Board Dynamics within companies as a major investment criteria. Seventh, the enactment of major financial regulations (like the Dodd Frank Act in the US) in many countries during 2008-2014 has changed the uses credit ratings and regulation of CRAs. Eighth, the issue of whether credit ratings in various countries are Public Goods has not been addressed in the literature. Ninth, the relationship among Credit Rating Agencies (CRAs) and systemic risk and Contagion is somewhat symbiotic and well documented - Sy (2009) summarized some elements of this relationship. However, its widely acknowledged that in most countries, the regulation of CRAs remains woefully inadequate, and despite the significant resultant social-welfare losses, un-regulated CRAs are allowed to operate. Tenth, the Global Financial Crisis of 2007-2014 has exposed significant weaknesses in the compensation and business models of CRAs. Many of the CRA business models and compensation schemes developed by governments and individual researchers remain very ineffective. Eleventh, the Global Financial Crisis of 2007-2014 has exposed significant weaknesses in the compensation and business models of CRAs. Many of the CRA business models and compensation schemes developed by governments and individual researchers remain very ineffective. The inefficiencies inherent in the compensation contracts for, and business models of CRAs were also clearly illustrated during the Asian Financial Crisis of the 1990s, and the Latin American Debt Crisis of the 1980s and the Global Financial Crisis of 2007-2012 (during which ABS Trusts and some large companies suddenly defaulted without prior downgrades of their ratings).