Credit rating agencies originated in the early 20th century in the United States, closely tied to the development of the American bond market. In the latter half of the 19th century, the United States experienced the Civil War and large-scale railroad construction, both of which required substantial funding and, therefore, facilitated the flourishing of the bond market. To assist investors in assessing the credit risk of bonds, several professional credit rating agencies emerged.

• Credit rating agencies have two main profit models: the issuer-pays model and the investor-pays model.
• The mistakes made by credit rating agencies during crises have prompted calls for regulation and reform. Various international organizations and countries have introduced relevant regulations and measures.
• While credit ratings provide investors with more information, they have also significantly increased the market's reliance on ratings. Although ratings are not infallible, they remain an important reference and serve as the starting point for many analyses.

The Big Three Rating Agencies

Moody's traces its history back to 1900 when two publishing companies were established by John Moody, the inventor of modern bond credit ratings. The success of the specialized market assessment publications led to the early rating system of some industrial firms and utilities. In 1914, Moody established the company "Moody's Investors Service." Since then, rating agencies in the modern sense have officially emerged. Ratings later expanded to various financial products and evaluation subjects.

In 1924, Standard Statistics Bureau began issuing bond rating manuals, and in 1931, Poor's Publishing also started issuing similar manuals. The two companies later merged to become Standard & Poor's. In 1936, Fitch also began publishing bond rating manuals. These three companies gradually became the largest credit rating agencies in the United States and globally, collectively known as the "Big Three."

The Great Depression led to the rise of Keynes' government intervention theory and financial regulation theories based on market failures. This prompted increased regulatory oversight of financial institutions by the government. To address the problem of evaluating the value of risky securities, regulators began accepting rating agencies' assessments of bond risks.

In 1975, the U.S. Securities and Exchange Commission (SEC) granted "nationally recognized statistical rating organization" (NRSRO) status to these three agencies, leading to their monopolization of the international rating industry to this day.  

Rating agencies experienced rapid development in the mid to late 20th century, expanding their influence and scope. The rating scope of agencies expanded from bonds to various financial instruments such as stocks, loans, securitized products, and derivatives. It also covered various debt issuers, including governments, corporations, financial institutions, and non-profit organizations.

Meanwhile, rating agencies expanded their footprint globally, entering Europe, Asia, Latin America, and other regions, providing crucial references for sovereign credit ratings in various countries. Additionally, the profit model of rating agencies underwent changes, shifting from the investor-pays model to the issuer-pays model. In other words, debt issuers pay rating agencies to obtain credit ratings.

Profit Models of Rating Agencies

Credit rating agencies have two main profit models: the issuer-pays model and the investor-pays model.

Initially, rating agencies primarily provided financial information services and charged investors who used rating reports, without publicly disclosing ratings. However, as the market became more complex and diversified, the investor-pays model faced the problem of information spillover. In this model, paying investors would transmit the received information to others who would not pay for it.

The mismatch between the revenue source (paying investors) and the beneficiaries of ratings (all investors) resulted in insufficient income to support rating activities. Consequently, the rating market gradually shifted towards the issuer-pays model. Under the issuer-pays model, debt issuers pay credit rating agencies to obtain credit ratings, which are then publicly disclosed to all market participants.

However, the issuer-pays model also brought new issues. Rating agencies might provide overly high ratings to maintain business relationships with issuers or lower rating standards to gain more fees. Such rating information apparently conflicts with the interest of investors.

The 2008 Financial Crisis

Originally, banks granted loans to borrowers with below-average credit and transferred the ownership of housing mortgages to securitization companies, who packaged them into mortgage-backed securities(MBS). These MBS were then sold to investment banks, which packaged them with other bonds into collateralized debt obligations (CDOs).  

Credit rating agencies played a prominent role in the global financial crisis of 2008, since a significant number of problematic bonds were rated as investment-grade. Prior to the eruption of the financial crisis, many subprime mortgage-related securities were given the highest AAA rating, indicating that they have practically no default risk as bonds issued by the U.S. government. However, this clearly did not align with reality.

Following the crisis, these rating agencies also faced legal action from U.S. authorities. Moody's was ultimately fined $864 million, while Standard & Poor's faced a penalty of $1.5 billion. The mistakes made by credit rating agencies during the crisis sparked calls for regulation and reform. International organizations and countries have introduced various regulations and measures to enhance the accountability and transparency of credit rating agencies, reduce rating failures and abuses, and protect the interests of investors and the market.

Still Indispensable

In the wake of the financial crisis, the United States House of Representatives deliberated and passed the "Credit Rating Agency Accountability and Transparency Act" in December 2009, amending the Securities Exchange Act of 1934 to strengthen regulatory oversight.

In July 2010, the President of the United States officially signed the "Dodd-Frank Act." The law, in the subsection C of its title 9, " INVESTOR PROTECTIONS AND IMPROVEMENTS TO THE

REGULATION OF SECURITIES”, established legal provisions for the regulation of credit rating agencies. The Securities and Exchange Commission (SEC) was granted authority to supervise and inspect credit rating agencies, as well as to develop new regulatory rules for the credit rating standard. With the continuous adjustment of regulatory rules, the development of the rating industry has also undergone adaptations.  

Today, in international markets, the “Big Three” still dominate the current rating market. Many professionals in the financial, legal, accounting, and economic information industries rely on their ratings. Although ratings are not infallible, they remain an important reference standard and a starting point for analyses.

The three major rating agencies control around 90% of the global rating market. Taking the European market as an example, data released by the European Securities and Markets Authority (ESMA) in 2023 revealed that these three companies accounted for over 90% of all paid ratings, covering a wide range from government bonds to corporate debt and structured financing. In terms of market share, both Standard & Poor's and Moody's experienced a slight decline, from 50.1% and 32.8% to 48.6% and 31.5%, respectively. The third-ranked agency, Fitch Ratings, increased its market share from 10% to 10.2%.  

Differences and similarities among Credit Rating approaches and processes  

The credit rating processes of the three major agencies follow similar structures. Taking the Standard & Poor's (S&P) rating framework as an example:

• First, the assessment begins by evaluating the company's business risks, taking into account factors such as market competition, country risks, and competitive advantages or disadvantages.
• Next, the analysis focuses on the financial risk profile, with particular attention given to management's financing decisions, the structure of the balance sheet, and the stability of cash flow to fulfill the company's financial obligations. These evaluations are combined to establish an anchor rating as a reference point. Other factors like diversification, capital structure, financial policies, liquidity, management, and governance are also considered.
• Finally, a rating committee composed of analysts and senior credit officers reviews the analysis to determine the rating. Once the rating committee makes a decision, the rating agency continues to monitor the rated issuer, tracking changes in its financial condition, industry dynamics, or other factors that may affect its creditworthiness.
• Regular rating reviews are conducted to assess whether the assigned rating remains appropriate or requires modification.

Nevertheless, the three rating agencies differ in the specific weights assigned to details and the sample periods used for default calculations. The differences in focus can be summarized as follows:

• Standard & Poor's: Uses a static pool analysis, evaluating the operational and financial risk profiles of issuers separately and providing indicative ratings based on the operational-financial risk matrix.
• Moody's: Utilizes dynamic group analysis techniques, establishing rating methodologies for different industries and placing special emphasis on four categories of factors: size and business conditions, operating performance and volatility, financial policies and financial strength, which further include more specific factors.
• Fitch Ratings: Also utilizes dynamic group analysis techniques, considering factors such as industry conditions and operating environment, company profile, management strategy and corporate governance, ownership, support and group factors, and financial condition. Fitch's assessments typically cover operational records, financial data, and Fitch's predictions of future performance.  

The static pool method involves creating a pool at the beginning of each year that includes all rated issuers and tracks their default performance, without factoring in the impact of rating withdrawals. In the event of rating withdrawal or default, issuers are removed from the pool going forward but not affecting the historical pool.

The dynamic group method involves creating groups of issuers categorized by ratings at the beginning of each year and tracking rating changes and defaults. Issuers with rating withdrawals are excluded from all groups, tracing back to the original group.

Both methods have their advantages and limitations, thus different ratings have varying degrees of reference value from different perspectives.

Can Credit Ratings Be Trusted?

Credit ratings provide investors with valuable information but have also significantly increased the market's reliance on them. The ratings issued by NRSROs are crucial reference standards for financial regulation, leading to a heavy reliance on NRSRO ratings by regulatory bodies. In the case of bonds issued by U.S. companies, the dual ratings from S&P and Moody's account for over 90% of the total, while for non-U.S. companies, the dual rating proportion is around 60-70%. This indicates that the majority of bonds require dual ratings.  

Investors also heavily rely on ratings, and rating changes directly impact the financing costs for issuers and the volatility of bond prices. However, from an investor's perspective, rating information should be used as a reference rather than the sole criterion for making judgments. So, can credit ratings truly be trusted?  
A study conducted by Harvard Business School titled "Do Rating Agencies Behave Defensively for Higher Risk Issuers?" suggests that rating agencies today are more defensive than before the 2008 financial crisis. Due to self-protection motives, credit rating agencies are more cautious and thorough in their ratings of high-risk issues.

The current monopolistic situation in the industry is expected to persist, and the regulatory dependence on ratings further solidifies the "chartered" nature of rating agencies. Regulatory enforcement and the reputational pressure brought by network effects to a certain extent regulate the behaviours of rating agencies.