Rating Agencies: A convenient scapegoat!
The familiar scenario of pointing the finger to the Rating Agencies has predictably remerged as a consequence of the “Sub-prime” credit crisis. As was the case during previous instances of market turbulence, the highest political authorities (in this case Chancellor Merkel and Prime Minister Prodi among others) have questioned the (ir)responsibility of the Agencies for not adjusting their ratings in timely fashion implying that market participants are being misled. Simultaneously calls for a reassessment of the market structure for credit ratings including the evaluation of the need for a “regulatory” framework are resurfacing as indicated last week by The European Commission who intends to address this question.
Before considering any form of intervention it is necessary to have a correct understanding of the exact role and functions of the credit rating market which is very widely misunderstood.
A preliminary remark is both important and obvious: the blame for the “speculative” excesses that have lead to the current “sub-prime” crisis can, under no circumstances, be laid at the door of the Rating Agencies but must be clearly attributed the lack of professionalism and supervision of the credit institutions whose greed has led them to overextend themselves, often by violating their own internal risk management policies.
To the extent that banks are involved, rather than pointing the finger at the Rating Agencies, it would be more appropriate to investigate why the existing regulatory framework (embodied in the Basle II agreements) is not proving to be effective. One should consider in particular how the required approval by the Banking Regulators of coherent risk management programs is being implemented and what procedures are in place to monitor compliance.
Rating Agencies occupy a special position in the market because, though they are not active participants, their actions can have important consequences. The fact that over the past fifty years they have been blamed equally for acting “too late” (as in the current crisis) or for acting “too soon” in other instances, precipitating the failure - or at least significantly endangering the survival - of major companies (often with serious redundancy implications deplored by the same authorities), proves that, on the whole they have probably fulfilled their task quite adequately.
It is useful to remember that Rating Agencies are “private” corporations. They deal in a commodity which has very special characteristics involving first and foremost the “trust” of their customers. This trust is based on a three way relationship:
- The Agency must be seen as:
o “independent” : that means not subject to any form of outside pressure;
o “professional” : that means it can demonstrate a long standing track record of providing appropriate credit assessments;
“trustworthy” : that means that rated companies must
feel totally confident that confidential
- The (user) Client must understand the characteristics of the product that is being offered: ratings are an indication concerning the likelihood that a given debt security shall be honoured at maturity. Under no circumstances does it relieve the client from exercising his own judgement.
Client must understand that it is in his interest to furnish correct and
Calls for intervention in the Rating market can be attributed to the small number of existing Agencies - largely dominated by “American” firms - which appears to give them inordinate “market” power. It also raises the question of objectivity, mainly in the minds of Public Authorities and/or non American “rated” Clients.
Globalisation plays a major role in making it even more difficult for new entrants in the market. Indeed, the interconnection of markets makes it necessary to offer - from the start - a “global” product with comparable evaluation standards (adjusted to local circumstances). This requires a major long term commitment. It will take indeed many years for a new company to break even in this market as it needs to build a substantial “track record” to reach the credibility necessary to justify the rating fees. This explains why previous attempts to set up Rating Agencies sponsored by the Public Sector (too local and not considered as objective) or under the control of institutions having imbedded conflicts of interest (banks) have not succeeded.
Despite this monopolistic position, any form of Regulatory intervention must be considered with great care as remedies can easily become counterproductive. Indeed, the independence (real and perceived) of the Agencies is probably their most valuable asset which needs to be preserved at all costs. Imposing any formal “standards of performance” on the Agencies would largely inhibit their actions reducing substantially the value of the service provided. It would appear more appropriate to rely on the need of the Agencies to preserve their reputation rather than attempt to regulate “trust” which is a concept that does not lend itself to such manipulation.
An additional aspect of ratings, which has complicated the understanding of the sector, derives from the “reference” often made to ratings in several aspects of the financial market’s overall regulatory framework. In the United States, for instance, maintaining and monitoring the solvency of institutions involved in financial markets, often involves reserve requirements (hair cuts), the importance of which is determined by reference to the “ratings” attached to securities owned (the lower the rating, the higher the reserve); in Europe the ECB refers to ratings when defining the “quality” of securities acceptable as collateral. This “official” use of ratings has therefore automatically raised the question of the status of the Agencies and the need for supervising their activities. It also raises questions of “discrimination” against “unrated securities”. This specific aspect however should not be made an excuse to interfere with the independence of Rating Agencies but must be understood as a simple convenience adopted by Regulators for simplifying the fluidity of market transactions.
For all the reasons described, it appears difficult to intervene in the Rating Agency market, either by creating by fiat additional “credible” competition, either by imposing “performance” standards or by submitting the Agencies to a constraining regulatory framework.
probability, the best results can be obtained by a broad
Paul N. Goldschmidt
Director, European Commission (e.r.)