Have the observers become dangerous players

International credit rating agencies (CRAs) are increasingly coming under scrutiny from governments for possible tighter regulation as suspicion is growing that their supposedly neural role as mere observers is not as clearcut as it should be. South Africa, where planed legislation to have them register has already been announced, last week became the latest example of an apparent attempt by an agency to play an activist role beyond just clinical credit rating.

Rand Merchant Bank (RMB) described last week’s decision by Moody’s Investors Service to place South Africa’s credit rating on negative watch (meaning it is considering lowering the rating) as “somewhat of a surprise”.

In an admirably restrained reaction to the news, South African Reserve Bank Governor, Gill Marcus described the move as “cause for concern.”  Noting the fact that the move was mostly based on an interpretation of political factors, she said “…you could also ask the question of whether the Moody’s interpretation (of the political situation in the country) is accurate.”

She added that the agency should engage with the political leadership of the country to address the issue.

For their latest view on South Africa’s credit rating the agency have relied heavily on soft issues, such as  what they called “growing political risk”.

Remarkably they also decided to change the outlook of South Africa’s top five banks from stable to negative. On the very same day another of the top three ratings agencies, which dominate the industry globally, improved South Africa’s Banking Industry Country Risk Assessment (BICRA) from group five to group four (with group one being the lowest risk and group 10 the highest risk), stating: “Our low risk assessment of the institutional framework reflects our view of prudent regulation and supervision within the banking system. This has been demonstrated by the early adoption of international accounting standards and Basel III capital requirements.

“In addition, with continuing foreign exchange controls, South African banks have only modest international exposure. The banking sector also displays good governance and transparency.”

In her response to Moody’s change of outlook on South Africa’s top five banks, Marcus said: “Our banks are very sound. We are one of the banking sectors that has not had a crisis so I’m not quite sure what they’re seeing there because it’s not what we see.”

Rumblings in Europe

On Thursday last week Standard & Poor’s had to admit that they mistakenly issued a downgrade of French sovereign debt. The reaction in the European Union (EU) was less restrained in its reaction than South Africa.

Moves to curtail the influence of the three largest, American-dominated RCAs (Standard &  Poor’s, Moody’s Investors Service and Fitch) have been coming for some time as they are increasingly  seen by policy-makers as an oligopoly that fomented and exacerbated market turmoil globally and more recently in the euro zone.

"This reinforces my conviction that Europe must have rigorous, strict and solid regulation for credit rating agencies," said Michel Barnier, the EU financial services chief who wrote a draft bill that will be published this week.

A key element of the draft bill will reportedly be a civil liability framework in the case of serious misconduct or gross negligence, Barnier said in response to the S&P error which sparked major market moves.

The 27-country EU-bloc has already approved two rules; forcing CRAs to seek European registration and a second requiring them to report directly to a new EU regulator.

The South African Treasury also recently indicated that it will follow the global trend in regulating CRAs, releasing for public comment a Cabinet-approved draft bill which proposes that credit agencies be registered. The draft Financial Markets Bill proposes tightening the regulation of financial markets and securities exchanges and would replace the Securities Services Act.

The draft bill also provides for the regulation of unlisted securities and the over-the-counter market. This would address weaknesses posed by the lack of regulation exposed by the recent financial crisis.

The need to regulate credit rating agencies also became apparent during the crisis as a result of the favourable ratings they gave to "subprime" securitised instruments. Many investors relied on these ratings, only to discover later that this confidence was sorely misplaced.

The draft bill will require credit rating agencies to register and lays down the conditions for registration as well as the agencies’ duties. It requires that they adopt a code of conduct and sets out rules of disclosure.

It is especially the timing of announcements by CRAs that has angered policy-makers and authorities in different countries and led to question about  whether they are really just neutral observers or at times attempt to influence the glow of events.

Authorities in the EU have been gunning for the big three CRAs since the financial crisis of 2008, with anger coming to a head last year when Greek debt was downgraded in the midst of  tense negotiations on that country's first €110bn bailout.

Coming for some time

The battle over the almost god-like position that CRAs have acquired since America’s then president Richard Nixon, for domestic convenience, decided to remove gold as the standard for the value of the dollar – the world’s currency of last resort – has been building up for some time.

CRAs are privately owned agencies that specialise in investigating the credit worthiness (ability to pay back) of governments and companies. CRAs assign credit ratings for issuers of debt-like securities (such as, bonds in the case of governments) that can be traded.

In the absence of a neutral yardstick --  like gold reserves -- and deregulation of the financial sector since the 1970s, CRAs have been allowed to take a centre stage and all powerful position in the global financial system.

The US, in particular, during the 1970s, passed legislation which allowed for the creation of the Nationally Recognised Statistical Rating Organisation (NRSRO). It effectively increased the barriers to entry for smaller firms and led to the consolidation of the industry by the big three.

According to a 2009 paper by Pragyan Deb and Gareth Murphy of the London School of Economics, of the top three global CRAs, S & P and Moody’s control 80% of the market. Fitch, the third biggest rating agency, lags far behind with approximately 15%  market share. All of the top three agencies are based in the US and dominate the global financial markets with their advisories.

The way the system functions is however fraught with conflicts of interest. These arose because of the way in which revenues were generated after the deregulation of CRAs. Over time the CRAs switched from an investor-pay model to an issuer-pay model. In an investor-pay model, the investor subscribes for a rating and in an issuer-pay model; the issuer pays for the cost of the rating, making the CRAs income dependent on the institutions they are supposed to rate on a neutral basis.

Evidence compiled over the years shows that this switch of source of revenue for rating agencies tended to also result in large issuers getting far more favourable ratings than before – the ‘notching’ effect coming into play.

The record of CRAs has not been all that good for some time now. In 2003, the Financial Policy Forum, an American non-profit body that monitors disruptions and inefficiencies in financial markets, published a special policy report, which argued that CRAs systematically failed to anticipate currency crises from 1979-1999.

Probably the beginning of the end for the untouchable status of CRAs came with the fact that they either did not see the financial crisis of 2008 coming, or for the sake of their big clients looked the other way.

They vouched for companies, loans and financial instruments that turned out to be awash with toxic debt. For example, Lehman Brothers was given a “triple A” rating shortly before it went bankrupt.

It has also since transpired that some of them also helped their clients, especially investment banks, design the instruments that brought about the financial crisis.

It is difficult to see the CRAs ever regaining the levels of trust needed to fill the gap left in the global financial system by the absence of a neutral benchmark of value and credit worthiness of something as tangible as a bar of gold.

Piet Coetzer