Rating agencies take centre stage – again

The decision  by credit ratings agency (CRA) Standard and Poor’s on Friday 13 January to downgrade the ratings of nine euro-zone member states, including France, has angered European politicians, rekindled accusations of an American conspiracy against on the European currency and brought fresh calls that the wings of the agencies should be clipped. But, the lack of credible alternatives seems to suggest that a solution to unsatisfactory financial regulation probably lies elsewhere.

The present complaints that the CRA’s has become too powerful, too American-biased and moving beyond what should be their mandate is not new. This is just a new crescendo in the financial drama that started with the American sub-prime bond-crisis of 2007-09.

Ironically, in the wake of the sub-prime crisis the CRA’s were criticised that they did not do their job properly in warning about the risks associated with some of the complicated financial products that were flooding the markets. Now they stand accused that they, by the content and timing of their pronouncements, are no longer just assessing risks, but attempting to directly influencing policy.

This accusation is fuelled by phrases in S&P’s statements such as this one: “As the European economy slows, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand shrinks in line with citizens’ concerns about job security and disposable incomes, eroding the revenue side of national budgets.”

There were also direct criticisms of political leadership in Europe, triggering angry responses from politicians, like German foreign minister Guido Westerwelle who suggested that the EU should maybe set up its own ratings agency – a debate that flares up from time to time.

There were also sharp responses in the European media, as illustrated by an opinion piece in the Süddeutsche Zeiting, which wrote among others: “... the S&P downgrade is particularly dangerous for another  reason. The agency hasn’t just expressed its opinion as to where investors should invest their billions at what risk. Rather, they have launched an attempt to directly intervene and influence European politics. That is not the job of a rating agency. The Americans have become increasingly open in their attempts to push the Continental Europeans to adopt the Anglo-Saxon economic and financial model. That means printing money whenever necessary in order to bail out banks or to finance economic stimulation packages. Those who don’t play along get bad ratings.”

Lessons from history

Ratings agencies have been around since 1909 when John Moody became the first financial analyst to assign letter grades to railroad bonds, giving investors an easier way to evaluate the rail companies’ debt after he himself went bankrupt in a financial crisis in 1907.

In 1916 Poor’s Publishing (which later became Standard & Poor’s) started selling its bond ratings , Fitch followed in 1924. In the 1930s federal regulators in the US began using private ratings to evaluate the safety of banks.

While the CRA’s have grown into one of the most crucial and powerful institutions of the modern-day financial system and capitalism, their record is a chequered one, as an extract from an article in The Economist of December 2010 illustrates: ”We all know how atrocious a job the credit rating agencies did in the run-up to the financial crisis. And yet far from sinking into obscurity and irrelevance, as one might have assumed, they have if anything become more influential. ... and (as) the sovereign debt crisis intensifies, the economic fate of many countries rests on the assessments of these agencies; they are courted by governments, lobbied by finance ministers, all in a desperate attempt to safeguard their finances from an investor exodus.

“Should we be surprised at this remarkable survival story? Perhaps not, if history is any yardstick. According to a working paper from the Bank of International Settlemens, the rating agencies completely failed to foresee the Great Depression and the 1930s sovereign debt disaster. In the run-up to World War II, more than half the countries which had issued debt in New York the previous decade defaulted – an economic catastrophe which certainly contributed towards the nightmare years that followed. But on the basis of the ratings appended to that debt even months before by the ratings agencies, you would hardly have guessed that the greatest sovereign debt disaster in history was looming.”

Another problem area developed in the early 1970s when they were switched from a investor-pays system to one of an issuer-pays system, creating a potential conflict of interest – a rating agency might post its rating upward so as to keep the issuer happy and forestall an issuer taking its business elsewhere.

As the reaction of the markets to the latest downgrades in Europe also indicated, some empirical studies have documented that yield spreads of bonds start to expand as credit quality deteriorates but before a rating downgrade, implying that the market often leads a downgrade and questioning the informational value of credit ratings.and treating a downgrade as just one of its sources informing investment decisions.

Potential changes

Some legislators in the US are pushing for the establishment of a ratings agency board that would assign credit rating agencies to rate each specific structured financial product. Issuers would still pay for the rating, but would not be able to shop around for the most friendly agency.

Others suggest a move back to the system where the investors pay. This would, however not completely deal with the potential conflict of interest, but only shift it to where investors shop around for an agency best aligned with their own investment bias.

Yet another idea is to remove ratings from private-sector institutions altogether by creating public-funded and administered institutions. There is no reason whatsoever to believe that such bodies would be free of political manipulation and more trustworthy in a world where the issuers of sovereign debt are such big players in the market.

The agencies themselves argue that although there is a potential conflict of interest under the present system, there is however no evidence that the business model played a role in the misjudgements that led to the American sub-prime crisis.

It should alse be kept in mind that it is the regulatory environment as it is structured at present from which CRAs derive their powerful position. This also holds true for the global environment, where the Basel II accords, for instance, absolved banks from the need to hold capital reserves against any sovereign debt rated above AA-.

To date CRAs have given role-players a convenient shortcut out of themselves doing comprehensive homework on financial products that are often extremely complex.

At this stage there is no credible alternative in sight and for the time being, despite the misgivings of governments and some regulators, CRAs will retain their central role in the global financial system.

A good start might be to create regulatory coordination across jurisdictions and sectors that in the medium to longer term could facilitate the improvement of risk assessment instruments, since the concerns associated with the present dispensation are of a global systemic nature.