Rating agencies and the opportunities available to the financial markets

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Credit ratings issued by rating agencies (“CRAs”) play a fundamental role in financial markets[1]by using their technical expertise to reduce the information asymmetry that exists in the financial markets.

Given their importance for financial markets, credit rating opinions must meet standards of quality and integrity of the rating process, independence and avoidance and/or management of conflicts of interest, and accountability to the investing public and issuers. Rating agencies also ensure that they have appropriate governance and risk management structures in place, as well as the required training for their analysts and staff.[2].

The role of credit rating agencies in financial markets is potentially valuable from the point of view of investors and issuers. With regard to the former, rating agencies act as an investor protection mechanism[3] or financial guardians[4]: they help investors and others sift through the vast amount of information available in the market and analyze the credit risks they face when lending to a particular borrower or buying debt or securities comparable to a debt of an issuer[5]. Regarding the latter, the credit opinion issued by a reputable rating agency is a key element of the issuer’s debt raising plan: indeed, it has been argued that the success of a debt raising by an issuer depended on the rating of the debt, with the rating a precondition that determines the interest rate offered and the cost of capital[6].

Despite the valuable role of credit rating services, there have always been a series of concerns associated with the rating agency industry.

The first limitation is the strong possibility that a conflict of interest exists between intermediaries [CRAs] and those it should protect, namely the investors[7]. This conflict would stem from the funding model [“issuer-pays model”]that would challenge the services of the CRA for the unbiased rating of the securities of the companies that generate their income[8]. Other factors of concern include, among others (i) the lack of competition in the market[9](iii) lack of an appropriate liability regime (which facilitates misrepresentation and negligence) and lack of independence from political and economic pressures[10]and (iii) insufficient quality of ratings[11] due to inadequate internal processes, inadequate analytical staff or incorrect application of rating methodologies.

In this context, the use of artificial intelligence (AI), if implemented correctly and with adequate controls and transparency, has the potential to reshape the structure of the sector, increase competition and improve the quality of ratings, with an emphasis on the most complex financial products.

In capital markets, some data provided by market participants suggests that automation leads to increased efficiency and overall it is likely that increased automation will improve the net resilience of institutions and support statutory objectives .

The use of AI would certainly have an impact on market information: the level of information asymmetry will decrease and transparency will improve thanks to the likely emergence of technology companies providing credit ratings, increasing thus the choice for investors.

From a market perspective, it appears that the use of AI by rating agencies may require as a prerequisite the loading of large amounts of financial data into the rating agencies’ repository systems. To achieve this, rating agreements will need to ensure that adequate safeguards are included with respect to the use of issuer data within ARC’s internal systems for the purpose of using AI.

This, in turn, would be very positive for the market structure of the credit rating agency sector, which is mainly dominated by the ‘big three’: Moody’s, Standard & Poor’s and Fitch Ratings, ‘by allowing ‘rating agencies to low cost ‘to enter into the market and provide services’. This will be fully in line with regulations at EU level (ESMA) where it is expected to promote the increase of market share of small agencies.

It should also be noted that the desire of regulators to promote competition is also present in other jurisdictions such as Argentina, where the Argentine Capital Markets Law 26,431 has promoted the existence of public universities acting as than ARC, to compete with traditional ARCs.

Therefore, an increased level of competition resulting from the use of AI will incentivize rating agencies to provide better and higher quality services, to compete on the merits, to improve their own rating methodologies, internal processes and to focus on expertise and complex financial products, to hire better staff.

All of the above would help to virtually eliminate the conflict of interest arising from the issuer-paid model, as more market participants would have access to their own research, so that any [mistaken] a rating of convenience would have serious repercussions on the reputational capital of the CRA.

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