How do Fitch, Standard & Poor’s, Moody’s and other global rating agencies work?

While bad news accumulates on the French economy front and the Prime Minister has presented his draft budget, the Fitch rating agency must decide, Friday October 11 in the evening, whether it downgrades or maintains the financial rating (AA−) of France.

During previous deadlines, these rating agencies had chosen to maintain France’s sovereign rating, but the Ministry of the Economy had been scolded by Fitch’s previous decision, which had downgraded the French rating in June 2023.

Standard & Poor’s, Moody’s and Fitch: these three names regularly appear in economic news, accompanied by an evaluation, from good student (AAA) to dunce (D). But what exactly do these ratings cover? Do you have to pay to be rated, and how much? Who are these evaluators of the global economy? What problems can their operation and economic model pose?

What is a rating agency?

It is a company whose purpose is to evaluate the financial health of another company or a public entity – State, city, department or region. The rating agency mainly studies the ability to repay debts, a criterion that interests investors the most.

Analysts write different scenarios and calculate the probability of each scenario occurring, based on the financial inflows and outflows of the entity being rated. They sometimes use data provided by the company examined or those from institutes such as Eurostat or the National Institute of Statistics and Economic Studies (Insee).

The agency also takes into account more global parameters such as, for France, “the social and political pressures illustrated by the demonstrations against pension reform” to use the terms of Fitch’s April note. Ultimately, the agency agrees on a score presented in the form of letters, from AAA (good solvency) to D (bankruptcy). Moody’s stops at C, with a slightly different rating system from the other two.

Who are the “Big Three”?

Three rating companies, all American, share most of the market globally: Standard & Poor’s, Moody’s and Fitch. In 2022, the “Big Three”, as they are nicknamed, held 93% market share in the European Union. And, despite the recommendation of the European Securities and Markets Authority to favor one of the seventeen other minority accredited agencies, these three behemoths continue to reign over the ratings. The French public entities that have ordered financial ratings since 2017 have not followed this recommendation and have all resorted to one of the three giants.

One of the “Big Three”, Fitch, had French capital until 2018. Then owned by Fimalac, owned by billionaire Marc Ladreit de Lacharrière, it was finally sold to the American media group Hearst Corporation. Its two competitors belong to two groups specializing in economic information, S&P Global and the conglomerate Moody’s Corporation, partly owned by billionaire Warren Buffett. As these two companies are listed on the stock exchange, they are required to detail their financial results: over the past ten years, they have more than doubled their turnover despite a lower number of ratings.

What are the consequences of degradation?

When an agency gives a lower rating to an entity, it is said to downgrade the rating. In turn, it also deteriorates its borrowing conditions; as there are few objective benchmarks on the financial markets, this rating, even if it is only indicative, will influence them very strongly – it is even mandatory in the management of large accounts.

A BNP Paribas specialist confided during a Senate investigation in 2012 : “All professional clients, from the Nordic pension fund to the Asian central bank, who have years of reserves ahead of them, have set their management rules based on the rating [notation] : no limit for triple A, limit for double A, no more than 5% for A, ban thereafter. »

Each change in rating is monitored by the different players, because this determines whether – and how much – a State, a community or a company can borrow from investors, and at what rate. For example, in 2009, when the rating agencies suddenly downgraded the ratings of subprime mortgages, their value melted on the markets and several investment funds went out of business.

The European debt crisis, during which a large part of the countries of southern Europe were relegated to high-risk categories, perfectly illustrates this phenomenon, as detailed in 2012 the governor of the Bank of FranceChristian Noyer: “It became very clear in Europe during 2011 that the prophecies concerning debt sustainability could be self-fulfilling. They push up risk premiums and interest rates, which requires generating larger primary surpluses and makes it more difficult to achieve budgetary balance. »

How do they make money?

Since the 1970s, rating agencies have changed their business model; they were previously paid by the end users of their notes, particularly banks, who were looking for a safe place to put their money. From now on, they are paid by the entity, public or private, that they evaluate: their client is their object of study. Only certain ratings are free, those of the richest countries, because they concern players who are essential to establishing a reference. We then talk about ratings “unsolicited”explains Agence France Trésor, which manages French debt, rated free of charge.

In parallel with these sovereign ratings, other public entities can request to be rated in order to then raise capital on the debt market: regions, departments, cities, hospitals, etc. According to its latest contract, the City of Paris thus budgeted nearly a million euros over four years for its rating and “the monitoring of [sa] credit quality ». On May 9, as a result of the deterioration of the French rating, it saw with eleven other local authorities its rating lowered to AA−.

More and more companies are requesting a rating (+20% in ten years). Agencies are very cautious when it comes to giving their rates, but according to several sources, an agency receives several tens of thousands of euros to rate an SME, and up to a million euros for a major bank or a large insurance company.

On the other hand, the segment prospered at the beginning of the 2000s with sophisticated speculation products such as subprimes declined very significantly following the financial crisis of 2009 caused by the explosion of the American real estate bubble.

How are conflicts of interest prevented?

The new economic model places agencies under suspicion of a conflict of interest. Indeed, agencies may be tempted to soften a rating to ensure that the rated company, their client, will be satisfied. In an email, obtained by a US Senate Commission of Inquiry On the sidelines of the 2009 crisis, a Standard & Poor’s executive raised the possibility of changing the rating criteria so as not to lose certain clients, who could turn to the competition if they were unhappy with their rating. Today, agencies ensure that there is total sealing between their commercial department and that of analysis.

Europe only addressed the question of the control of these controversial financial players after the 2009 crisis. The European Securities and Markets Authority, with which the agencies must be accredited, can now initiate investigations if potential violations are identified. In the worst case, agencies can even lose their accreditation.

In 2019, Fitch was fined more than 5 million euros for not having complied with legislation on the prevention of conflicts of interest, noting the Casino group, of which Mr. Ladreit de Lacharrière was a director at a time when he still owned the agency through his holding company. In 2021, it is Moody’s which receives a total fine of 3.7 million euros (shared between its five European branches) for having rated several entities in which its shareholder Berkshire Hathaway had shares.