KOREA CAPITAL MARKET INSTITUTE

To facilitate a credit bond market, it is necessary to improve functions and roles of the credit rating system, one of the most important bond market infrastructure. Due to its short history, undeveloped credit bond market and repetitive credit events, Korea’s credit rating agencies have yet earned sufficient confidence among stakeholders. For higher confidence, the overall regulatory framework should be enhanced by figuring out the industry’s current problems and analyzing changes in overseas regulatory frameworks.

By conducting an in-depth review on Korea’s problems in the credit rating industry, this study aims to devise effective ways to improve CRAs’ fairness and confidence. For this, I use Korea’s credit rating data to analyze credit assessment’s adequacy and timeliness, to review issues surrounding the industry, and to identify problems the industry currently faces. Based on the analysis, I propose plans to improve Korea’s regulatory framework and market structure for Korea’s credit rating industry. 

According to a series of analyses on various industry data, Korea’s credit rating industry appears to have the following problems. 

First, confidence in Korean CRAs is not so high although changes in the corporate bond market structure have increased the importance of credit rating. The not-so-high confidence in CRAs seems to have stemmed from failure to timely adjust ratings at the time of a credit event, and inappropriateness of ratings amid issuer’s high influence. 

Second, issuers’ influence is high in Korea’s credit rating industry. A look at the impact of the credit assessment structure on ratings confirms a market structure giving advantages to issuers under the current issuer-pays model, a conflict of interest affecting the appropriateness of credit assessment.

Third, Korean CRAs show some problems, e.g., deepening homogeneity of ratings, and failure to differentiate their services in terms of rating standards, determinants, and opinions. Their rating splits once peaked at 18.3% in 2000, but fell to the 4% range at the end of 2014. Rating changes in the following years of rating splits occurrence show a far higher percentage of issuers whose rating is upgraded than those with rating downgrades. Such a phenomenon is presumably the result from CRAs’ efforts to address rating splits: A CRA who awarded lower ratings actively tries to upgrade its ratings with reference to other CRAs’ higher ratings.

Fourth, rating standards show a low level of consistency. There is a certain period of relaxed rating standards, during which ratings tend to go up. A regression analysis using multiple variables and year dummies shows a statistically significant impact of most financial variables affecting corporate creditworthiness on corporate ratings. In particular, a regression using year dummies show that year dummies from 2010 to 2013 are high with statistical significance. Moreover, another analysis between model ratings and actual ratings for a certain period shows consistent results: Rating splits between 2010 and 2013 remain significantly high. This can be interpreted as more generous rating standards during that period. Such relaxed rating standards serve as one of the factors undermining confidence in credit ratings among stakeholders. 

Fifth, bond default rates according to credit ratings are found higher in Korean CRAs compared to global CRAs. If a broader concept is used to define default events, ratings fail to be timely adjusted prior to a default event. In a sample of defaults in the narrow sense, ratings are adjusted timely, but this does not occur in defaults in the broad sense. A possible explanation for this could be difficulties to detect a credit event in advance because any broad-sense default event such as a workout or debt restructuring tends to be led by a creditor bank, which limits CRAs’ ability to timely adjust credit ratings.

Also analyzed in this study are post-crisis regulatory trends for overseas CRAs. By adopting inappropriate analysis techniques and vague internal procedures, CRAs misjudged creditworthiness of asset-backed securities. Also, improper regulation over credit ratings amplified the problem. Other problems in the industry include CRAs’ sideline business, conflicts of interest due to the fee structure, and an oligopoly dominated by a small number of CRAs. Furthermore, the industry being under-regulated due to the heavy focus on market discipline and reputation was criticized as one of the causes behind the global financial crisis. This increased the necessity for stronger regulation over CRAs, and accordingly, international bodies and regulators across nations have overhauled the relevant regulatory framework. The overall direction of the overhaul is tougher regulation and oversight while loosening the licensing for CRAs, more stringent disclosure rules for better transparency, and less conflicts of interest. As part of attempt to address conflicts of interest, various plans are currently under review, e.g., introducing a new fee structure and a designated CRA system, and reducing heavy dependence on CRAs. 

In June 2007, the US enacted the Credit Rating Agency Reform Act in order to improve credit rating quality for investor protection and welfare by pursuing CRAs’ legal accountability, transparency, and more competition. 

This was later revised in April 2009 with the focus on stronger disclosure duties on CRAs, and more sophisticated rating of structured securities, and the introduction of the code of conduct. Also the Dodd-Frank Act that came into effect in July 2010 strengthened CRAs’ liability, addressed conflicts of interest, and improved rating procedures with better internal controls and transparency. Also included herein is Securities Exchange Commission(SEC) plans for stronger regulation over CRAs and reduced dependence on CRAs. Through those reforms, more nationally recognized statistical rating organizations(NRSROs) were designated, and the Office of Credit Ratings was created in the SEC for monitoring, on-site inspection, and research on regulation and oversight over credit assessment. But improvements on the designated CRA system, fee structure, and less dependence on credit rating will be materialized after further examination.

Europe also has pushed to overhaul its credit rating regulatory framework since the global financial crisis. In 2009, the Proposal for a Regulation of the European Parliament and of the Council on Credit Rating Agencies was enacted to be used as a common, EU-level standard while allowing for each nation’s financial supervisory authority to oversee credit rating. Later in May 2011, the legislation was revised(CRA2) for a centralized supervisory regime governed by the European Securities and Market Authority(ESMA). This was subsequently revised again(CRA3) in May 2013. 

The latest revision not only strengthened sovereign rating transparency and monitoring over rating procedures, but also created foundations to introduce civil liabilities for CRAs. Also, the conflicts of interest regulation for ratings was extended to rating outlook. On top of this, another plan was introduced to report individual CRAs’ fee to ESMA. But reduced dependence on CRAs and mandatory rotation included in the initial proposal were regarded as long-term agenda and left undone. 

Based on the aforementioned analysis results, I propose Korea to make the following improvements to bolster the function that credit assessment should play in the credit product market.

First, multi-faceted efforts should be made to improve confidence in CRAs. The most important factors for this should be enhancing credit ratings’ appropriateness and timeliness. Hence, CRAs should exert diverse efforts in this area to win confidence among stakeholders. 

Second, it is desirable to devise plans to resolve conflicts of interest between issuers and CRAs. The current market structure with issuer advantages may serve as an element to undermine the appropriateness of credit ratings. On top of a regulatory framework to reduce issuers’ influence, CRAs should also make self-help efforts to reduce dependence on issuers. 

Also recommended are structural improvements, e.g., introducing an investor-pays model, and improving fee schemes, etc.

Third, persistent improvements are necessary in the regulatory framework for CRAs. Through two major reforms in CRA regulation, Korea achieved the intended effects of enhancing CRAs’ fairness and accountability. Going forward, Korea should make ceaseless efforts for regulatory improvements in response to changes surrounding credit assessment. And the overall direction for improvements is to strengthen CRAs’ functions and roles as professional, independent credit assessment.

Toward that end, it is wise to introduce a comparative disclosure regime publicizing default rates. CRAs should devise a uniform guideline to publicize credit assessment performance, and enhance consistency of relevant standards. In addition, the appropriateness of ratings should be enhanced via a comparative look on default rates that have various definitions. Also necessary are widening the base for credit products that are subject to credit assessment, and improving the usage of credit ratings. For CRAs to improve their independency and fairness, it is worth considering a credit rating fairness report adopted in Europe as part of attempts to address conflicts of interest.

Among others, Korea should improve the current market structure giving advantages to issuers in order for Korean CRAs to earn more confidence. CRAs must improve its fee revenue structure to reduce their heavy dependence on issuers. Furthermore, regulatory authorities should review changing the fee structure in reference to global regulatory improvements in this area.