Tackling Transparency: ESMA Eyes Ratings Opacity

Pan-European regulator the European Securities and Markets Authority (ESMA) is currently developing a strategy for increased supervision of credit rating agencies (CRAs), in response to complaints from market participants of unreasonable price rises and a lack of transparency around the CRAs’ pricing models.

Prior to the financial crisis, rating agencies were encouraged to follow the International Organization of Securities Commissions (Iosco) guidelines, a global set of standards. After the crisis, the Dodd–Frank Act regulated rating agencies in the US, while the CRA Regulation has been in place in Europe since 2009, amended twice, in 2011 and 2013. The 2011 update made ESMA the direct supervisor of rating agencies, giving it the power to register rating agencies that want to rate instruments in the EU, the power to investigate if the agencies are complying with the regulation, and the power to sanction any poor behavior.

“The overall objective of the CRA Regulation is to make sure that CRAs operating in the EU provide quality, independent and objective ratings,” says Louise Riley, senior competition expert at ESMA. “The idea is to ensure that the CRAs are competing fairly.”

Since 2013, ESMA has focused on setting up a system for supervising this requirement, and in 2014 held an industry consultation process, canvassing views about competition and choice.

“Through that, we learned a great deal about the concerns that market participants have about the fees charged for credit ratings and ancillary services, including quite frequent increases and a lack of transparency in pricing,” Riley says. “We took the responses that we received to the call for evidence and incorporated that into technical advice that we published in 2015, and that was provided to the European Commission.”

“The ECB has set up enormous barriers to recognizing other rating agencies, even a rating agency like ours that is the largest post-crisis agency in the world. This is how the incumbent rating agencies maintain their position.” Jim Nadler, Kroll

The consultation resulted in a delegated regulation in 2015, which mandates that agencies must annually report their fees and pricing policies to a dedicated IT system so that ESMA can identify discrepancies and compare fees for similar services, and generally monitor the agencies.

“We went through a period of testing the IT system at the beginning of 2016, and then went live over the summer,” Riley says. After a great deal of hard work, ESMA is now collecting information about CRAs’ pricing documents, their fee schedules and pricing policies, as well as details of the individual fees that they are charging for credit ratings and ancillary services.

“We are collecting input from a variety of sources—from the IT reporting systems we have set up, from the experiences of market participants, and from our own market monitoring,” she says. “We have been learning of a number of issues regarding fees and costs, and so we are considering those now, hoping to come up with a supervisory strategy that will allow us to effectively police the relevant provision of the regulation. I can’t say too much about what that strategy is likely to look like because we can’t pre-empt what we haven’t published yet, but we are hoping that something will come out early next year.”

Public Data, Premium Packages

To say that market participants have concerns about the fees charged by CRAs is an understatement: In October 2015, Inside Market Data reported on end-user objections to “unreasonable” fee increases from ratings agency Fitch Ratings. Now, just over a year later, the situation has worsened, say sources at asset managers in Europe.

S&P, Moody’s and Fitch provide ratings on the creditworthiness of companies and the debt they issue, charging the issuer under a model known as “issuer-pays.” The ratings themselves are generally freely available—anyone can Google that Deutsche Bank is rated BBB- by S&P, for instance. However, financial institutions subscribe to the rating agencies for information besides ratings, such as datafeeds and packaged solutions that they draw into their own systems for risk, compliance and Basel III capital adequacy calculations, among other functions. 

One source at a European asset management firm says Fitch in particular has proposed significant fee increases for ratings data. Before, the source says his firm was paying Fitch somewhat less than it paid S&P and Moody’s, which are generally considered more mature offerings. Fitch’s initial proposed increase was about four times what the asset manager was paying the others. The firm negotiated it down, but Fitch is still quoting more than twice what the firm would pay for the others, the source says.

But what concerns the asset manager more than the cost itself is the lack of transparency into how the fees are calculated, which hampers firms’ ability to manage these rising costs. “The cost gets unmanageable if you don’t know what variables impact the fees, and this is the case now. If we knew it was dependent on the number of ratings or locations using them, or assets under management, then we could optimize and control our own spend. But we can’t do that because they are not transparent.”

A Fitch spokesperson denies it is being opaque: “Fitch is in regular dialogue with its clients and other key stakeholders to ensure the fees for its ratings and research products are competitive and transparent and, furthermore, that any proposed changes to fees are clearly communicated in a timely manner.”

Blame Game

A rating industry expert who has worked at one of the agencies, defended the fee increases, saying the agencies are under regulatory scrutiny and have to charge comparable clients equal prices. 

“Clients pay different prices for the exact same service; you have some paying a lot, others that are on extremely favorable contracts. What Fitch has tried to do, because there is a lot more regulation involved now, is level the playing field. What they don’t want is a top-tier bank paying less than a tier-two bank, for example, when the two banks use the same service in the same way.”

European regulation does in fact specify that differences in fees charged for the same type of service should be justifiable by a difference in the actual costs in providing the service to different clients, and the source says regulators question rating agencies about big discrepancies in what clients pay, insisting that ratings fees are usage-based, but noting that clients’ usage practices have changed since many of the contracts were written years ago.

Agencies don’t just dictate their fees, he says. “We go in with a 15- or 20-page proposal and we show customers where their counterparts are. We don’t give them up by name, but we do say, here are the tier-one banks, this is what they are paying, and here is what you are paying, and you are €400,000 below and need to be brought up to that level.”

‘The 95-Percenters’

The complaints about Fitch are the latest in an ongoing conversation about what some call an oligopolistic market for ratings. ESMA has described the market at an international level as a platform market, or a market that brings together two different communities of users, one or both of which could be charged. Such markets tend to be concentrated and have high barriers to entry, says an ESMA report.

According to data from ESMA’s CEREP database, the big three agencies own 95 percent of the European ratings market. Fitch claims about 15 percent, with the rest more or less equally split between Moody’s and S&P. The remaining 5 percent is shared by 38 rating agencies registered with ESMA to operate in the EU. Historically, this dominance originates from regulation in the US, which officially recognized only a handful of rating agencies that then consolidated into the Big Three through mergers in the late 1990s. Their dominance is entrenched on both sides of the Atlantic, while the smaller niche agencies typically offer geographical or industry-specific expertise. 

The EU’s CRA Regulation requires that rating agencies must ensure that their fees for ratings and ancillary services are not discriminatory and are based on actual costs. While the asset management source disputes this, he concedes that S&P’s model is disclosed. The rating agency bases its calculations for asset managers on size of organization (measured by assets under management), frequency of delivery, and scope of the ratings. “S&P Global is committed to transparency and to pricing that reflects the value provided to the market,” says an S&P spokesperson.

A source at another European asset manager, says charging by AUM is an aggressive tactic to increase revenues. “They are shifting away from a model of actual usage and pinning it on levels to which they can stick higher fees, such as AUM. And I say to these firms: My growth has no relation to how much income you should get. Your fee should be determined by how much value you provide for me, and not on whether my business is a success,” the second source says. “They tell me it’s the best way to understand how the data is being used. But if I’m not dealing heavily in fixed income portfolios, the actual number of instruments that I pull in would be less than another firm with a lower AUM. That is entirely possible and yet it’s not reflected in their calculations.”

Reducing Reliance on Ratings

ESMA most of all recommends that firms move away from “sole and mechanistic reliance” on rating agencies. Yet, says Jim Nadler, president of Kroll, one of the alternative ratings agencies that hopes to make its mark, regulations designed to protect investors may have unwittingly resulted in authorities protecting incumbent CRAs, making it harder for regulators and investment firms alike to reduce this reliance. 

“One of the most striking examples of how the incumbent rating agencies are protected, even after everything they have done, is the European Central Bank (ECB),” which has a list of four rating agencies that are accepted by the Eurosystem: the Big Three and the Dominion Bond Rating Service, Nadler says. “The ECB has set up enormous barriers to recognizing other rating agencies, even a rating agency like ours that is the largest post-crisis agency in the world. This is how the incumbent rating agencies maintain their position—not through the quality of their service, but because of the protection they are provided by investment guidelines and the rules of institutions like the ECB.”

Post-financial crisis, regulators have cajoled investors to perform more of their own research, rather than just relying on ratings. But the vast majority of these investors are smaller firms without the resources to do this themselves, which depend on data from the rating agencies to support their decisions, Nadler says.

“The vast majority of investors just have the major rating agencies on their investor guidelines, which means that they are hard-wired into using the incumbent rating agencies,” says Mauricio Noe, head of Kroll’s European operation. “You get crazy situations where you have investors suing the big agencies but continue having them on their guidelines. Before I joined Kroll, I used to be a user of rating agencies on the investment banking side. I have never encountered another industry where people are forced to pay for products that they hate. Maybe broadband in London is the only equivalent!”

The second asset manager source agrees that financial institutions should learn to reduce their reliance on the rating agencies. 

“Customers are forced to do business with all of the Big Three. But when I say ‘forced,’ it’s not these players forcing them. That’s the mentality of the customers believing they must deliver for their own customers and for regulation. But if they are wise and put in a little effort, they can maybe choose two of the three and then use their own capability to create a composite value. You would still have to use two services, but that would give you a bit of bargaining power,” he says. “The credit crisis illustrated that to rely solely on rating agencies is a dangerous practice. But people have bad memories and we are back where we began. There is the belief and culture among consumer firms, regulators and auditors that it is healthier to have all three, but this isn’t true. It would be healthier for firms to have a certain amount of control themselves. Firms should choose two of the three and apply their own methodology, creating new infrastructure.”   

But unless there is also a mindset shift to incentivize the use of alternative providers, then however disruptive ESMA’s upcoming supervisory strategy proves to be, the ratings space will continue to lack real competition—and hence, competitive pricing.