Tuesday, 27 August 2019

Article Preview – ‘A New Era for Chinese Credit Rating Provision’ – Journal of Business Law

Today’s post previews a forthcoming article by this author that is due to be published in the Journal of Business Law. The article is available in its pre-published format here. The aim of the article is to assess the new development within the global credit rating arena, in that China has allowed Standard & Poor’s entry, as a stand-alone entity, into its marketplace for the very first time. The move to allow the largest global credit rating agency into the Chinese market, without having to be aligned to a domestic agency, is unprecedented. Considering that Moody’s has apparently set up a stand-alone entity and is in the process of applying for the licence to operate within China, the article discusses the environment that the agencies are entering, whether there is a need for them at all, and if so then why.

The article starts by analysing the development of the credit markets in China, which naturally leads to the development of the internal credit rating market. Through a number of actions by the state in the late 1980s and beyond, credit rating became a necessary function. In response, the People’s Bank of China (PBoC) would develop rating divisions which would, in time, be spun off into stand-alone rating agencies – a number of Chinese domestic rating agencies can trace their origins to the central bank. However, as a response to the Asian Financial Crisis in the 1990s, the Chinese appetite for credit, and with it credit rating agencies, was rapidly diminished. The Chinese regulators took a similar approach to the American regulators, essentially producing ‘licences’ for certain firms to continue their rating businesses (akin to the ‘Nationally Recognised Statistical Rating Organisation’ status given out by the US Securities and Exchange Commission). These agencies – China Chengxin, Dagong, China Lianhe, Shanghai Brilliance, and Shanghai Far East – became the core of the Chinese credit rating market and through the late 1990s to the mid-2000s, the regulators sought to fence off the marketplace. In line with this state-controlled marketplace, foreign entities like S&P and Moody’s were only allowed to operate in China if they were working in conjunction with an established Chinese rating agency.

However, the regulatory regime for CRAs in China has been, traditionally, fragmented. The article discusses the issues that emanate from a fragmented regulatory regime, but the result was a foreseeable one. After the Financial Crisis, Dagong especially was active on the global scene – this author has written an article on the Universal Credit Rating Group, which saw Dagong join forces with Egan-Jones Ratings and RusRatings in order to challenge the hegemony of the Big Three. Despite all the positivity surrounding the challenger, the tide has turned and the agency finds itself under mounting pressure. In 2018 Dugong had its domestic licence suspended for a year on account of its consultancy business and its effect between it and its clients. The article discusses how research has suggested that the Chinese rating marketplace is riddled with inherent issues, issues based on a variety of problems that stem from a prevalence to inflate ratings based upon market concentration to an oligopolistic marketplace that is attempting to guard against foreign entry. The result has been for the domestic credit rating market to lose its reputational authority just at the time the Chinese need it the most and, as such, the Chinese government has taken action.

The article discusses the Chinese environment and its ascension from a colonial victim to a global powerhouse. As such, China is now looking outward but needs investment in order to make that aim a reality. That investment requires foreign investors to trust the Chinese marketplace more than it does, and the domestic Chinese credit rating agencies, for a number of reasons, cannot make that happen. It is for this reason, the article suggests, that China has now opened its doors to the global credit rating agencies. Irrespective of the issues that seem to be inherent within the Big Three, they continue to act as the ‘signaller’ to the global capital markets, and China really needs access to those markets. The article concludes by examining this concept further and calling for more research once S&P, and more-than-likely Moody’s set up shop on the country permanently. The fact that S&P has developed a China-specific entity, rather than apply its global set of methodologies, has raised questions as to the usefulness of the connection, but the rewards on offer for the global capital marketplace means that if the global CRAs give the go-ahead to invest heavily in the Chinese marketplace, then the dynamics of the global marketplace may be very different in the near future.


Keywords – China, Credit Rating, S&P, Business, @finregmatters

Thursday, 22 August 2019

Article Preview – ‘Sigma Ratings: Adapting the Credit Rating Agency Model for the Anti-Money Laundering World’

In today’s post we will preview an article by this author that is due to be published soon in the Journal of Money Laundering Control. The article is available in its pre-published format here. In this post we will review the underlying premise of the article, and present the target of the article which is a new venture in the anti-money laundering arena – Sigma Ratings.

The article aims to introduce the new venture to the literature and examine its potential against the backdrop of the anti-money laundering (AML) arena, and also against the experiences of its model-sharing cousins, the credit rating agencies. For clarity, Sigma Ratings is essentially a mixture of the two worlds and seeks to bring the credit rating model into the AML arena, with the hope being that the agency will enable the world to ‘transact with confidence’. To achieve this aim, the article presents a number of different contexts. The first context presented is that of the AML world and some of the competing theoretical pressures that underpin it. This is followed by an analysis of the banking arena and its importance to the concept of AML, before the article concludes by introducing Sigma Ratings and then discussing some of its potential strengths and weaknesses.

Money laundering is contextualised genealogically at first. We see that the concept of money laundering is a long-existing one, but efforts to formally combat it emanated from the 1980s and the spread of drugs around the global system. The links between money laundering and organised crime are analysed closely, because as one scholar notes, ‘money laundering has become instrumental in both the success and collapse of organised crime’. This is emphasised by the statistical notion that estimates suggest that the money laundering industry is the world’s third-largest industry behind oil and agriculture, which demonstrates the societal importance of affecting this particular sector. In attempting to understand the theoretical underpinnings of money laundering, we see that there are a number of competing pressures that influence the development of AML efforts, including political, economic, and legal-based concerns. In utilising the systems theory lens, it is discussed that these competing pressures produce inefficiencies that are systemic to the AML effort – the reasoning for this is, potentially, that the systemic nature of AML is not properly considered by those who can affect the regime, and the result is that many initiatives tend to focus on the symptom rather than the cause.

This concept is examined from within the context of banking. We start by seeing that banking is widely recognised as being one of the crucial ‘pinch-points’ for money laundering and, thus, the global AML effort. However, the dynamics of banking in general, and in ‘correspondent banking’ in particular, are advanced to show that there are a massive number of pressures on the banking system when AML is considered. It is suggested by scholars that banks were ‘unwillingly recruited’ into the AML regime and that this is based on a number of aspects. Those aspects are discussed in the article and range from the increased cost of participating in the regime, particularly when placed against the lack of opportunity to derive profit from the expense. It is discussed that there have been attempts to correct this imbalance, most notably with the invention of ‘Financial Inclusion’ (FI), which aims to open previously untapped markets to the banks as a sort of quid-pro-quo for their AML efforts. FI includes categories such as low-income individuals, rural sectors, or undocumented groups, but a large amount of the focus is in developing countries. However, the aims of tempting banks into FI as some sort of reward for increased AML compliance have not come to fruition, with it being suggested that there exists a massive fear of dealing with entities from other jurisdictions when their practices are not fully vetted – this is the issue with ‘correspondent banking’ and is one of the main issues that underlies some of the headline-grabbing stories of massive banking penalties for AML failures for institutions such as HSBC and BNP Paribas.

It is within this gap that Sigma Ratings, potentially, is best suited. The article introduces Sigma Ratings to the literature and some of the declarations form the new company are assessed. The agency declares that they are different to the recognised ‘Big Three’ rating agencies in that Sigma rate entity-level ‘non-credit’ risks such as financial crime compliance and governance. Sigma is championing its usage of ‘deep domain expertise and cutting-edge computer science’ in order to generate a number of risk scores for companies around the world. One of the founders of the company – Stuart Jones – describes the company as the world’s first ‘business integrity rating agency’, which is particularly apt and contextualises the new offering nicely. The agency’s internal processes are discussed and we see that they have a simple rating system akin to that of the rating agencies – these simplistic rating scales are one of the key selling points in the rating arena – and a prescribed system for coming to a rating decision. The article goes on to discuss that, because of the agency’s adoption of the infamous ‘issuer-pays’ remuneration model, there exists a potential conflict of interest, but the article advances the notion that this may not be as prevalent as in the credit rating industry because regulators may be one of the key users of Sigma’s ratings, more so than in the credit rating industry. However, there still exists the potential of rating inflation, and this is something the article focuses upon and warns against. We see that Barclays have been involved in the funding of this new addition, and that this is not surprising given the potential importance to the banking industry via the concept of ‘signalling’ – the ability to convey to external bodies like investors but, more importantly, regulators, will be a key selling point to Sigma Ratings and the products that it develops.

The article concludes with a positive sentiment in that the new offering is particularly welcome and, if it continues to develop, will be of great benefit to the AML system. There are potential issues if the agency grows, but these can be off-set (or, maybe they will not be). Nevertheless, the agency is a welcome addition to the field of AML and will hopefully inject useful information into a system that needs clarity and, in a lot of cases, some simplicity. The ability to ‘signal’ to a number of entities should make the banking process, especially where money laundering and the fight against it is concerned, much more efficient and, therefore, potentially more systemically positive than it currently is. There is a widespread understanding that more is needed from the global AML effort and this offering that Sigma represents may be a positive addition on that regard.


Keyword – Sigma Ratings, Money Laundering, AML, Banking, @finregmatters

Tuesday, 20 August 2019

Failed Regulation in the Credit Rating Industry?

This post reviews a recent article in the Wall Street Journal, written by Cezary Podkul and Gunjan Banerji, entitled Inflated Bond Ratings Helped Spur the Financial Crisis. They’re Back. Regular readers will know that the credit rating agencies and their performances over the past two decades have been reviewed extensively and critically here in Financial Regulation Matters on account of the author’s specialism. However, whilst there has been repeated criticism of the agencies themselves, the regulators and their post-Crisis attempts to constrain the industry deserve more attention. The WSJ article suggests that post-Crisis regulatory endeavours have failed and this falls in line with a thesis of this author who has suggested that regulators are regulating imagined, or idealised entities rather than the agencies and the industry as it actually exists. Therefore, we will review the article and ask what its findings mean for post-Crisis regulation in the credit rating arena.

The fascinating article begins by declaring that ‘inflated bond ratings were once cause of the financial crisis. A decade later, there is evidence they persist’. It is claimed that all of the top 6 firms have, since 2012, adjusted their rating methodologies which then went on to result in an increase in their market share. This has been centred upon the structured finance market according to the article, with the authors researching more than 30,000 ratings within a $3 trillion database from the established Big Three (S&P, Moody’s, and Fitch) and the three agencies that have emerged/been encouraged to challenge them since the crisis (DBRS, Kroll Bond Rating Agency, and Morningstar) – we reviewed the acquisition of DBRS by Morningstar recently here. The results of this research suggest, as the article states, that ‘a key regulatory remedy to improve rating quality – promoting competition – has backfired’. This is because the ‘Small Three’, as I will call them here, tended to rate bonds and structured finance products even higher than the Big Three did – the article suggests that on occasion the divergence between the two sets of ratings would be as wide as one being deemed ‘junk’ and the other being deemed AAA, which is a remarkable deviation on the same bond/product. This issue of rating inflation has been found by a number of researchers to exist, almost fundamentally, within the credit rating industry and this WSJ article suggests even further that it is perhaps an inherent characteristic of a credit rating agency (irrespective of whether the agency is an oligopolistic member or not). The influential Professor Bo Becker studied S&P in 2011 when they were shut out of the commercial mortgage-backed securities (CMBS) market and found that, once they could rate in that market again, S&P provided higher ratings than any of its competitors, which lead Becker to argue that this was done in the name of market share. Studies on this topic stretch back to the implementation of the ‘issuer-pays’ model with research from Jiang et al confirming that, when Moody’s incorporated the model and S&P did not, Moody’s ratings were higher – when S&P incorporated the model themselves 3/4 years later, parity was resumed at the higher level between the two rating giants.

The article goes on to cite senior credit analysts from Fitch who suggest that ‘I suppose that’s the flip side, isn’t it, of having more competition among rating agencies’ – the analyst is speaking about the article’s findings that DBRS rated a certain hotel deal as up to two rungs higher than Morningstar because it had just loosened its rating criteria (its then-competitor) and, as a result, its market share jumped by 26%. There is a further issue cited whereby a number of investors urged S&P to not loosen their rating criteria through a fear that changes would lead to a ‘weakening of credit protection for investors at a time where we need it most’ – S&P apparently rejected this call. This led former S&P employee David Jacob to argue that any loss in market share was attributed to harsher rating methodologies and those methodologies were, and continue to be altered accordingly. What is happening now, according to the article, is that the Small Three are attempting to make up for the massive chasm in market share between them and the Big Three by inflating their ratings excessively – DBRS is cited as rating CMBS bonds 39% (S&P), 21% (Moody’s), and 30% (Fitch) higher than its larger competitors (Morningstar and Kroll are apparently no better).

However, the Small Three have responded. Morningstar argued that there is bias in the data analysed by the WSJ because when the Small Three provide more conservative feedback to the issuers, they are often not selected as a result – Morningstar argue that if all of these (then) unpublished ratings were taken into account, then the picture would look very different. Fitch argue that rating diversity is good for investors and that they can take their investment decisions accordingly based upon the variety of ratings available to them. These defences raise a number of important questions which are worth considering.

First, the situation is different for the Small Three, and this needs to be remembered. There is a tendency in the literature (and this article in particular) to consider that all rating agencies are equal – they are not. The pressures on the Small Three are much more acute, and the relationship they have between themselves and the issuers are very different. The issuers have much more leverage, and also it is the case that just through sheer rating volume, unpublished ratings will skew the data set for any such analysis. We can see that the pressures are different with the Small Three as they have had to devour each other, in some sense, to stay alive. The DBRS deal is necessary at the lower end of the market, whilst the Big Three enjoy unrivalled oligopolistic status.

The second question this article raises is to do with regulatory efficiency. The article states that the regulatory action taken in the aftermath of the Crisis has ‘backfired’, but I would argue that the correct term is that is has failed. Any onlooker would have been able to see that the rating industry is not primed for increased competition by its very nature – the rating agencies in the oligopoly certainly do not want it, the issuers do not want it for the most part, and it will (and has) led to increased confusion and complexity for investors. I wrote about the EU’s attempts to do this in 2017 here and we spoke recently of how the EU is starting to admit that this policy is not working. The reality is as I suggested in my book Regulation and the Credit Rating Agencies – there is a massive divergence between the actual and the desired. Regulators and legislators wanted to be seen to be acting in the aftermath of the Crisis, irrespective of the validity of their actions. I argued after the $864 million fine given to Moody’s for its Crisis-era conduct that, for the regulators/legislators, their work was done. However, this is simply not the case and the market is now being burdened by those regulatory actions. The WSJ article cites Becker who states that reliance upon the agencies has gone from ‘high to higher’, despite the aims of the Dodd-Frank and three EU regulations that aimed to destroy that reliance by removal of references within regulation/legislation – Becker found that 94% of rules governing investments ‘made direct or indirect references to ratings in 2017, versus 90% in 2010’. Simply put, this is yet another example of reactive regulating/legislating.

So, what is the solution? That is the ‘million dollar question’ although, in reality, it is worth much more than that. One element that needs to be considered more is the role of investors. Regulators have failed in their quest to positively affect the industry. If we look at the agencies’ collective commitment to ESG principles recently – although we must be particularly cautious when attributing praise in this area just yet – it is clear to see that investor pressure is particularly potent. I discussed this in my book The Role of Credit Rating Agencies in Responsible Finance and it is unquestionable that action, linked to the agencies’ quest for profits, is the most affectual approach that is currently available. If there is a potential to make a lot of money, or a potential that investors will reduce their need for the ratings, then rating agency action will follow immediately afterwards. At the moment the lure of a new marketplace (sustainable finance) is partly determining agency performance and behaviour. The next stage of academic and professional insight must be how professional investors utilise market data for their investment needs. If it is found that, actually, credit ratings are useful to the process (although many esteemed scholars, such as Professor Frank Partnoy, have argued that they are not useful in this sense), then examining ways in which shareholders can institute pressure will be useful to the development to the marketplace. As for regulators, it is vital that they regroup and consider the benefit of reactive regulation. However, the more one thinks of it, it is perhaps legislators who need to develop the most. The thought of, say, the US legislature enacting impactful and potentially constraining reform within a bull market is seemingly unthinkable, and perhaps therein lies the issue – cyclicity in the marketplace tends to have only one consequence… more cyclicity.


Keywords – credit rating agencies, WSJ, rating inflation, @finregmatters

The Assault on Tobacco Continues, but what does the Future Hold for the Industry?

With the rise in sustainable and, to a point, ethical investing recently, there is now concerted pressure being placed upon the large tobacco companies from investors and policymakers. In today’s post we will look at this pressure and how it is building, and also in what direction the industry may move once the inevitable move from cigarettes and cigars takes place. There are suggestions that the traditional tobacco companies may move into vaping industries in a much more concerted way, but there are a number of potential issues awaiting them if they choose to do that.

A British governmental report this year proudly stated that there is an ‘ambition to go “smoke-free” in England by 2030’. This was accompanied by ‘an ultimatum for industry to make smoked tobacco obsolete by 2030, with smokers quitting or moving to reduced risk products like e-cigarettes’. This policy movement is being witnesses against a financial movement which is seeing the largest traditional tobacco companies being pressured to move into alternative markets by their own shareholders. Imperial Brands, one of the largest industry players, is currently facing a showdown with its shareholders who want to see a number of traditional arms of the company divested, in response to a consistent reduction in the share price over the past few years. It is being reported in the Financial Times that plans to divest the company’s cigar businesses is being deemed as not enough, with a wider divestment being targeted by the firm’s largest shareholders. Those same shareholders argue that a. ‘their core business is in decline’, and that b. ‘they are talking about moving away from combustible products, but that’s all they know. If you want a fresh outlook, you need a fresh team’. This request for a change in management is based on the belief that the company needs to move into e-cigarettes in a more systematic way.

All of the financial forecasts suggest that this move will be required. It has been suggested that the global e-cigarette market could reach $58 billion by 2026, from just under $10 billion in 2017. It has also been suggested that the leading tobacco firms could, and will move into the legal cannabis market, with one forecast valuing that particular market as being worth more than $150 billion by 2025 – as a response to a growing number of jurisdictions legalising the product. So, it is very unlikely that the large firms will struggle in the new environment, as they are already adapting to the changing environment around them. We should expect nothing less of course, but there are associated issues with this newly diversified growth. Perhaps the biggest issue, societally speaking, is that the move to e-cigarettes is becoming a potential ‘epidemic’ in its own right. This is the opinion of the US Food and Drug Administration who, in relation to teenagers using the products, recently warned that if the products were not kept away from those deemed underage, then there would be substantial penalties. This is based on the realisation that, as the products are under-regulated (particularly when viewed against cigarettes and cigars), there are three associated issues. First, the number of teenagers taking up ‘vaping’ is steadily rising. It is currently being suggested, via legal trials in the US, that Juul Labs (one of the leading Vaping companies) is actively marketing their products towards young people. Second, ‘vaping’ is being seen as a healthy alternative to smoking, even for those who are not smokers – a study recently suggested that 5% of vapers had never smoked before, but that the majority of vapers actually smoke combustible products too. Third, and most importantly, it is often perceived that vaping is ‘risk-free’, but this is apparently not the case according to a variety of studies. There are a number of potential health risks associated with the practice, In addition to this, it can be the case that alternative cigarettes contain more nicotine than traditional cigarettes, as it can be concentrated much more in the alternative forms. Combining this potential with the conscious marketing to the young and non-smokers, and it becomes clear that there is a potential of developing a new level of dependency. It is worth noting, however, that governments are seeking to regulate this element, with the UK capping the amount of nicotine that can be contained in any one cartridge to 20mg.

It appears that the future for the industry is one of adapting to its environment. The tobacco industry have been past-masters at contorting the environment to its will, but that era is about to end. Instead, the industry is being pushed, from outside and within, to move towards alternative technologies and products, all in the name of consumer and societal health. However, it is important to note that these companies have garnered extreme levels of wealth from dealing in products that are highly addictive and particularly harmful, and this (forced) shift in focus should not be construed as moving away from that profitable model. Juul Labs has become a massive player in the alternative cigarette market, and the traditional tobacco companies will surely be aiming to dominate that marketplace now that they are, essentially, being pushed into it. If that is the case, then how will these companies achieve that? It is almost certain that they will deploy the same tactics to dominate the new market (Juul is already 35% owned by the owners of Marlboro Cigarettes), tactics that will likely include pushing addictive substances, aiming towards ‘new’ demographics like young adults and non-smokers, and then raising prices. It is likely the case that a wave of negative sentiment and corresponding regulations will follow that phase, almost confirming the cyclical nature of this particular marketplace.


Keywords – smoking, vaping, e-cigarettes, business, law, @finregmatters

Friday, 9 August 2019

Karen Millen and Coast the latest High Street Casualties

In April 2017 we reviewed the story of Karen Millen, who had built her fashion brand into a 130-store chain before being declared bankrupt because of an unpaid tax bill. The brand, which was bought from Millen in 2004 by an Icelandic company before being transferred to Aurora Fashions in 2011, has been long regarded as a quality outlet on the British high street. However, with the seemingly-relentless demise of the traditional British high street, it appears there are about to be two more casualties.

In 2018 Karen Millen, owned by Aurora – who are ultimately owned by the Icelandic Kaupthing Bank – acquired certain parts of Coast, a competing fashion retailer who were launched in 1996 and grew to have almost 20 stand-alone stores in the UK. As Coast were in administration, Karen Millen were able to acquire certain parts of the Coast’s concession and online portfolio, saving 600 jobs in the process. However, it was confirmed this week that Karen Millen and Coast have been put into administration and, through a process known as a ‘pre-pack’, the businesses have already been sold. Yet, rather than another company taking on the brands and therefore the jobs associated with the two brands, the buyer is online retailer Boohoo. Boohoo are a Manchester-based online-retailer and have grown in prominence recently thanks to a concerted marketing approach aimed at younger generations, alongside a very successful media campaign that has seen the firm become synonymous with popular programmes such as ITV’s Love Island. Boohoo have purchased the online businesses of Karen Millen and Coast for £18.2 million, in a move which all but ends the existence of the two brands on the British high street and puts more than 1000 jobs at risk. Whilst the two brands have been losing money in recent years, Boohoo are optimistic that an addition to their revenue stream, in terms of opening up their business to a different clientele, will bear fruit soon enough.

Karen Millen has said that she is ‘deeply saddened to this think that this may be the end to the visible presence of the stores’, but this move is, of course, just the latest in a long line of store closures on the high street. The footwear store Office is due to close half of its stores in the UK, which number at more than 100. Boots has announced that there will be more than 200 closures from its extensive network. Furthermore, in terms of job losses, Tesco announced this week that more than 4,500 jobs across the country will be axed, with the store baling changing consumer shopping habits. It appears there are a whole host of factors that are affecting the health of the high street, but there are very few solutions in sight. The prominence of online-only retailers, the need for austerity-battered British consumers to conserve their finances, and uncertainty about the economic future of the country are all coalescing into a storm of problems for high street retailers. There will be more updates from the blog in the near future regarding store closures, regrettably.


Keywords – UK, high street, Karen Millen, Boohoo, business, @finregmatters