By Markus Krall, CEO of the new European Ratings Agency

Until very recently, the ratings industry was a rather dull, albeit profitable, sub-segment of financial services that only capital markets experts and treasurers had to take notice of. Looking back from what we know today, one might wonder how it could ever be perceived as so boring.

The industry is at the center of a heated debate that has reached the broader public in waves, starting with the subprime crisis in 2007, the banking crisis in 2008/09 and the sovereign debt crisis since 2010. The agencies have been subjected to criticism, some of it justified, some of it misplaced.

This recent history has produced some lessons regarding the role and desirable future shape of the ratings industry, which I would summarize as follows:

The ratings industry is of substantial systemic relevance. When it works well, it creates positive external effects by reducing the information asymmetry between borrowers and investors, thus fostering efficient credit markets and reducing funding costs for the private sector. If it doesn’t work well, it creates negative externalities, as we have seen in the crisis.

The ratings industry fulfills the role of "credit department to the capital markets." Just like the credit department of a bank, it provides the information required to understand and quantify the risk of credit instruments. If this function fails in a bank, the institution will sooner or later be in trouble as risks will accumulate in its portfolio, which are bound to materialize one day. The same is true for the agencies and the capital market credit portfolio. Errors in assessing the risk will lead to risk bubbles that lurk under the surface until they become too big to hide.

The systemic importance of ratings agencies is currently combined with a quasi-monopolistic market situation. Three agencies dominate the market with a total share of 95 percent; two of them share 80 percent of the market and a common shareholder base. This not only stifles competition, it also creates a concentration risk in the market, as literally tens of trillions of euro and dollar credit papers pass through an analytical bottleneck. If only one agency with a very large market share fails in its analytic approach, big misallocations of credit on a global scale are bound to happen. This was one of the root causes of the US mortgage bubble. However, the lack of competition has fostered even more uniformity in analytic approaches, compounding this concentration risk. This has become especially visible in the subprime market.

Monopolistic market power in combination with the conflict of interest inherent in the “issuer-pays” revenue model and a complete lack of product liability create a set of incentives that can (and did) amount to moral hazard. These incentives increase the likelihood of large-scale errors in assessing credit quality since those errors can even represent a lucrative business opportunity. The lack of product liability does not exactly add a corrective element to such incentives, as negligent or even intentional misconduct is not associated with painful sanctions.

The setup summarized above makes the financial system vulnerable, especially in times of fast product innovation on capital and disintermediated credit markets. It is no accident that the bubble was created in a rather new and arcane corner of the system, where tried and tested instruments of risk assessment were required. It is not sufficient, therefore, just to blame the events on a unique situation from which “the agencies have learned.” We can expect financial innovation to return sooner rather than later. The vulnerability of a system without checks and balances will then increase again.

To cure this unhappy state of affairs we have a choice between market-oriented solutions and bureaucratic or regulatory solutions, or a combination of both. Experience shows that while regulation of conduct is needed, that alone will not be able to provide stable long-term and cost efficient solutions for the markets. The strongest way to create a market-oriented solution is to create more competition. In this regard the ratings industry has presented us with a paradox: While profitability is very high, with returns on revenues of 40 to 60 percent (reflecting a monopolistic rent), the entry barriers have in the past been even higher. Economies of scale, reputation and networking make this industry what economists call a “natural oligopoly.” So it is necessary to find an operational model that can overcome the entry barrier.

Our approach to establishing a new globally active ratings agency is built on such a model. By adopting the credit risk assessment approach of banks, which is a combination of strong quantitative models (under the Basel II IRB implementation) and a subsequent highly structured qualitative analytic approach (which is performed by the credit departments), ratings can be created at a fraction of the cost and with provable track records and discriminatory power. This establishes credibility much faster compared to the traditional approach. In addition, the result is more transparent, easier to reproduce for users (such as investors) and can serve as a benchmark for investors not only in its end result but with every well-documented intermediary step.

This new agency would also voluntarily assume a well-defined and measured product liability toward investors and remove the fiction that ratings are just opinions. Setting these new behavioral standards would provide an alternative to market participants. It would reduce the systemic concentration risk by adding more choices, by providing more transparency and by strengthening accountability. It would contribute to more capital market stability in the future and reduce systemic risk, which is ultimately borne by taxpayers.

That is why we need a new globally active ratings agency with a fresh approach.