Reuters came out with an analytical article this morning which doesn’t bode well for the continued use of credit ratings. (See Analysis: Investors break their bonds to ratings agencies.)
It may be generally agreeable that several mistakes were made that (1) enabled credit raters to become too powerful, (2) allowed for their performance to continue unmeasured, unmeasurable and unaudited, and (3) hindered our ability for holding them accountable.
The resulting lowering of ratings standards is not unexpected – it represents our failure as much as theirs, as we’ve classically conditioned them to push the boundary in seeking extended economic rents. Let’s be honest, they’re for-profit companies providing opinions for which they aren’t being held accountable, and for which the negative-feedback-looping reputation mechanism is rendered inapplicable (they’re essentially a monopoly). Do we expect them to say “no” to receiving free cash?
But while it may be the easiest solution to simply remove them, I think we can all agree that the average investor will be no better in measuring risk in their absence. Yes we may agree their ratings hold little (or no) predictive content in certain areas of structured finance. Perhaps we would argue they shouldn’t have rated some asset classes at all. But does that mean that their expertise in rating corporate debt is superfluous, and should be foregone in its entirety? Do their corporate ratings provide no economies of scale in respect of the analysis of corporations?
It’s certainly popular to say “we don’t care about their opinions” – but certain investors do. Some investors are ill-equipped to perform the analysis required on a name-by-name basis. Moreover, it’s not necessary that all rating agencies be good at evaluating all types of debt. Perhaps some should focus on specific niche areas, and investors should learn to evaluate their relative levels of expertise in different areas. Being able to independently measure their performance helps inform investors’ determination as to which raters they care to rely on in each specific scenario.
The short-term solution is simple. Rather than berating them as a public evil, let us empower rating agencies to be a public good. It’s as fundamental as creating an incentive for them to be accurate, or a penalty for consistently being inaccruate. Penalties can be effective: one only has to suspend one license held by one rating agency for a short period of time (a “sit out period”). The other rating agencies will quickly ensure they’re dedicating the resources necessary to providing accurate ratings in that area. (Alternative forms of penalties include ratings fee clawbacks and other forms of legal accountability.)
The Reuters article points out that “[fund] firms contacted by Reuters said rating agency research tended to be backward-looking and superficial…” Perhaps we have only to incentive the rating agencies to be accurate, to dig deeper than endlessly assuming historical mean-reversion.
Per Kurowski
July 18, 2011
Of course we would all like and benefit from the credit ratings providing us with more accurate results… but that is not really the issue.
If you were a responsible regulator, what would make you toss and turn at night, that the credit ratings are correct or the possibility they are wrong?
If your answer, as expected, is the second, then try to explain the current capital requirements for banks that allow for extremely little bank equity when the credit ratings determine there is very little or no default risk at all, and which therefore are betting it all on the credit rating always providing correct risk information. Loony eh!
As a result of this regulatory silliness, the current crisis left our banks with no capital, simply because they were not required to have any capital against what was ex-ante rated as “not-risky” but that “ex-post” could turn out to be very risky.
Would you have not been a better regulator asking instead for capital requirements for banks that covered the case of the credit ratings being wrong? I bet you would!
One of the biggest challenges we face is finding a way to accept and internalize that the “expert” regulators appointed to such vital places as the Basel Committee for Banking Supervision, the global bank regulator, can really come up with so unbelievably unbelievable dumb regulations…
PS. Loony bank regulations explained in an apolitical red and blue! http://bit.ly/mQIHoi