Oct 5th 2010, 13:30 by A.P. | LONDON
COMPETITION is generally a good thing, but is it beneficial in finance? If banks expect a lower stream of profits in the future because of rising competition, then their incentives to take risks grow. There is a well-established line of thinking among bank regulators in places like Canada and Australia that reckons a less competitive industry leads to a more stable financial system.
A new NBER paper looks at the same question from the perspective of the credit-rating agencies. The paper, by Bo Becker of Harvard Business School and Todd Milbourn of Washington University in St. Louis, examines a natural experiment in competition—the rise of Fitch between the mid-1990s and the mid-2000s to stand alongside Moody’s and Standard & Poor’s (S&P) as the predominant ratings agencies. That rise was steep: in the median industry that the researchers looked at, Fitch issued less than a tenth of American corporate-bond ratings in 1997 but close to a third ten years later.
The authors find that this increased competition from Fitch coincided with a deterioration in the quality of ratings issued by Moody’s and S&P. First, there was ratings inflation, with more ratings rising towards the top of the scale as competition increased. Second, the correlations between issuers’ ratings levels and bond yields weakened. And third, the power of ratings to predict default went down as competition went up.
The paper assesses two theories to explain this “econometrically robust” negative relationship between competition and quality. One is ratings shopping: with more providers of ratings to choose from, issuers chose the firm that issued the highest marks. That explanation looks more plausible for structured products; in corporate bonds, the focus of the paper, it is less persuasive. That’s because agencies have a habit of rating publicly issued corporate bonds whether they are paid for it or not: shopping around does not eliminate other, less favourable ratings from the market.
The authors think the second explanation for the relationship between competition and quality more compelling. This says that by reducing expected future profits, competition reduces the reputational incentives to keep quality high. Those incentives may fade particularly quickly in an industry where it takes many years for ratings to be proven correct or wrong. Whether a ratings market with just two participants would have done any better during the boom is another question, of course. And there should be some offsetting benefits to investors from the availability of more information. But the argument that greater competition in finance itself requires more stringent regulation has got stronger.
economist.com/blogs/freeexchange
A new NBER paper looks at the same question from the perspective of the credit-rating agencies. The paper, by Bo Becker of Harvard Business School and Todd Milbourn of Washington University in St. Louis, examines a natural experiment in competition—the rise of Fitch between the mid-1990s and the mid-2000s to stand alongside Moody’s and Standard & Poor’s (S&P) as the predominant ratings agencies. That rise was steep: in the median industry that the researchers looked at, Fitch issued less than a tenth of American corporate-bond ratings in 1997 but close to a third ten years later.
The authors find that this increased competition from Fitch coincided with a deterioration in the quality of ratings issued by Moody’s and S&P. First, there was ratings inflation, with more ratings rising towards the top of the scale as competition increased. Second, the correlations between issuers’ ratings levels and bond yields weakened. And third, the power of ratings to predict default went down as competition went up.
The paper assesses two theories to explain this “econometrically robust” negative relationship between competition and quality. One is ratings shopping: with more providers of ratings to choose from, issuers chose the firm that issued the highest marks. That explanation looks more plausible for structured products; in corporate bonds, the focus of the paper, it is less persuasive. That’s because agencies have a habit of rating publicly issued corporate bonds whether they are paid for it or not: shopping around does not eliminate other, less favourable ratings from the market.
The authors think the second explanation for the relationship between competition and quality more compelling. This says that by reducing expected future profits, competition reduces the reputational incentives to keep quality high. Those incentives may fade particularly quickly in an industry where it takes many years for ratings to be proven correct or wrong. Whether a ratings market with just two participants would have done any better during the boom is another question, of course. And there should be some offsetting benefits to investors from the availability of more information. But the argument that greater competition in finance itself requires more stringent regulation has got stronger.
economist.com/blogs/freeexchange
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