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In 2008, Kroll Bond Rating Agency, as a new rating agency, is looking for the opportunity to enter the credit rating business, after key participants in the industry were criticized for bloating the mortgage credit bubble. The firm is challenged on how to level up with its key competitors, Fitch, Moody's, and S&P.
Harvard Business Review (212034-PDF-ENG)
October 19, 2011
Case questions answered:
- Jules Kroll of the Kroll Bond Rating Agency is planning to enter the credit rating business. Is this a good idea? Is this a good time?
- How did the incumbent credit raters fail in the financial crisis? How does this affect Kroll’s opportunity?
- What is the NPV of KBRA plans?
- If Kroll goes ahead with their plans, what do you feel is the best way to enter ratings? Consider staffing, financing, regulatory requirements, specialization.
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Case answers for Kroll Bond Rating Agency
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1. Jules Kroll of the Kroll Bond Rating Agency is planning to enter the credit rating business. Is this a good idea? Is this a good time?
There are a variety of considerations that Jules Kroll of the Kroll Bond Rating Agency should account for in his decision whether to enter the credit rating business. This type of business is an industry with relatively high barriers to entry and many challenges in achieving success.
One challenge is staffing the firm. The products created by Wall Street are often complex and structured in a confusing manner that may mask the security’s risk. Wall Street has the advantage of paying very high salaries to employees that create these lucrative products; rating agencies, however, often are not as profitable and therefore have a harder time attracting top talent.
Other challenges include building relationships with investors and issuers of these securities. Being a young firm certainly has its challenges; this lack of credibility is a significant factor.
Additionally, the revenue model of rating agencies has come under scrutiny following the recent mortgage crisis. Structuring revenue in a way such that conflicts of interest are minimized yet still profitable for the firm can be somewhat tricky.
Securing the NRSRO status from the government is another significant barrier to entry that would present a challenge to Kroll. This government designation cements a firm’s position as a reputable rating agency.
The resources required to overcome each of these challenges are significant; attracting investors to help finance the company may also be challenging.
That being said, the timing could be appropriate. The recent recession changed the public’s perception of rating agencies. Firms that could once be reliably trusted for offering accurate opinions on the quality of securities were exposed as highly flawed. Kroll Bond Rating Agency could capitalize on this opportunity to offer investors a new option, free of many of the flaws in the previous framework.
Ultimately, there will be a significant risk in creating a new rating agency. Still, I believe the market would be accepting of a new business model and would, therefore, recommend that Kroll pursues the creation of a firm.
2. How did the incumbent credit raters fail in the financial crisis? How does this affect the Kroll Bond Rating Agency opportunity?
From one side, the big three rating agencies failed to assess the structured finance instruments thoroughly. Rating these securities required modeling the return of each of the various constituent assets, as well as how they co-varied, and it is known that these asset-backed securities contained a large number of assets in the pool. Being mortgage-related securities, the main constituent of the rapid growth of structured finance during the 2000s, the home prices peak, and then the fell of home prices affected drastically structured finance securities starting in 2007.
The reaction from rating agencies was to start…
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