5.2 Brief history of credit rating agencies

The increasing number of raters has triggered serious questions about the role and credibility of ratings, has there is, among others, lack of transparency in the ratings process, inadequate focus on material issues, lack of comparability of companies across industries, conflicts of interest in organizations that offer services, alongside to conducting ratings.1 Ultimately, the following questions remain, are sustainability ratings needed? For what purpose and in which form? Why do we need ESG ratings? Are these ratings truly driving companies and society towards a more just and sustainable world for present and future generations?2

These questions cannot be answered without briefly looking at the pioneer credit ratings provided by the credit rating agencies. Credit rating agencies evaluate the creditworthiness of borrowers (generally their financial capacity). Only the credit risk is evaluated, market or liquidity risks are not part of the ratings.3 The European Commission defined credit rating as “an opinion regarding the creditworthiness of an entity, a debt or financial obligation, debt security, preferred share or other financial instrument, or of an issuer of such a debt or financial obligation, debt security, preferred share or other financial instrument, issued using an established and defined ranking system of rating categories;” and defined credit rating agency as “a legal person whose occupation includes the issuing of credit ratings on a professional basis;”.

The first credit agency was “The Mercantile agency” created in 1841 by the Tappan brothers.4 The Tappan brothers were in the silk business and had the habit of keeping detailed credit information about current and prospective customers. After the silk crisis in 1837, they decided to use all the information gathered during the years they were active in business, by opening a mercantile credit agency. Later in the 1900s John Moody, a Wall Street analyst developed interest in applying the mercantile ratings’ methodology to bonds.

In 1909 John Moody published “Analysis of Railroad Investments” a book with the first rating scheme for bonds.5 In 1914 started the Moody’s Investor’s Service and in 1922 it had a formal rating department.6 The second rating agency was Poor’s Publishing Company created in 1922 and the third was Fitch Publishing Company created in 1924.7

In the 1920s rating agencies’ work consisted of gathering and synthetizing valuable information and they were exclusively financed by investors’ subscription fees.8 According to Partnoy (1999) the ratings’ system and scales did not have a substantial change since the 1930s, differently from their size and revenues, as both exponentially grew since the seventies.9

In capital markets similar questions remain. Do we need credit ratings, why? Should credit rating agencies exist? The credit rating industry is a monopoly of the three largest credit rating agencies, US-based Standards & Poor’s, Moody’s and Fitch ratings, often referred to as the Big Three, which is considered since 2000 to be the main reason for the low quality of the credit ratings.10 From existing literature on financial reporting I have learnt that credit rating agencies mostly repeat what is already reported by financial news and downgrades are public after those news are public (Partnoy, 1999; Coffee, 2011), they do not add new information to the market (Macey, 2006; Fitzpatrick and Sagers, 2009; Rhee, R.J., 2015, pp. 163) and rely mostly on publicly available information (Rhee, R.J., 2015, pp. 163). Credit rating agencies have failed to predict financial crises and to provide valuable information before a crisis.11 These agencies usually make their ratings public in reaction to an already public event. In his research Partnoy (1999) has concluded that rating agencies became more important and more profitable, not because they generated more valuable information but because they began selling more valuable regulatory licenses.12 As a result of their failure in forecasting information, e.g. failing to predict the Enron and WorldCom corporate scandals between 2001 and 2002 (Coffee, Jr., 2014 pp. 247), they have come under intense scrutiny which led to two major legislative Acts in the US, the Credit Rating Agency Reform Act of 2006 and the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010, and in Europe to the European Securities and Markets Authority, created in 2011, to hold the credit rating agencies accountable and to protect investors.131415 Before 2006 in the US, and before 2011 in Europe, credit rating agencies were not directly regulated (Coffee, Jr., 2014 pp. 246).

Ratings have since then become a tool of regulation and this change originated a new credit rating agencies’ selling product (introduced by US regulators) changing the credit rating agencies business model, which has remained intact since then.16 Issuers have since started to buy a license from the regulators and this is the fundamental reason for paying their rating fees (it is not to purchase credibility with the investor community). Only the few rating agencies obtaining the Nationally Recognized Statistical Ratings Organizations status are allowed to sell regulatory licenses and this is regardless of their credibility within the investor community. A Nationally Recognized Statistical Ratings Organizations benefits from a maximum credibility within the Government and have their business safe irrespective from their reputation and credibility within the investors, which contributes to the low quality of the ratings.

Partnoy (1999) recommends the elimination of the regulatory dependence on credit ratings and suggests the use of credit spreads instead of including credit ratings in regulation.17 Partnoy (1999) also explains that, as credit spreads are determined by the market as a whole and not by any individual entity or entities, a credit spread- based system would not create regulatory licenses for any approved agency.18 Besides, credit spreads already incorporate the information contained in credit ratings and are as accurate as credit ratings.