Some Modest Suggestions for Rating Agency Reform

In the Financial Times, Avinash Persaud, an emeritus professor at Gresham College and a director of Global Association of Risk Professionals. offers some sensible recommendations for regulating rating agencies, first, standardizing their ratings definitions and second, changing the rating agencies’ incentives (although this idea is not spelled out in sufficient detail).

What is perhaps most interesting about the article, however, is not its recommendations but its assumptions. Persaud believes the ratings agencies will wind up being subject to greater oversight. Even if they are no longer in US lawmakers’ crosshairs, the Europeans have not forgotten, and they tend to be persistent about these things (consider the EU’s antitrust suit against Microsoft). He also believes reforms will put a dent in securitization, but does not believe the effects will be as serous as nay-sayers would have us believe.

From the Financial Times:

The soothing embrace of central bank liquidity has calmed credit markets for now, leading to a deep sigh of relief from the big three credit ratings agencies: Standard & Poor’s, Moody’s and Fitch. Just a month ago lawmakers were circling. But any relief could prove premature. As Christine Lagarde, the French finance minister, recently intimated, the appetite for regulation of the agencies in Europe remains high. Also, do not forget that the $1.4bn settlement between Wall Street banks and regulators, involving analysts’ conflicts of interest, was announced two years after the start of the dotcom collapse.

There are crucial differences between ratings agencies and analysts. Ratings agencies do not have the business model of star analysts bagging multi-million-dollar bonuses. Yet ratings are as much at the heart of the current originate, rate and relocate model of banking as analysts’ recommendations were to the dotcom boom. For seven years banks transferred large volumes of loans, to those who had little know ledge of the issuer, because the instruments carried a rating. Ratings widened the demand for these instruments to the point where banks made an easy living earning fees for originating, repackaging and transferring loans rather than expensively carrying them on their balance sheets. Banks were looking more like traders and some traders were looking more like banks. Regulators took the naive view that this was a good thing because risks were spread across more institutions.

One fundamental flaw with the originate, rate and relocate model of banking is that credit risks were being transferred, in part, to traders of risk who did not intend to hold on to these instruments for a long time and so had little incentive to invest in learning more about them. In effect, what they were trading was the rating. During periods of low volatility this leads to some efficiencies, as traders arbitrage differences between similarly rated instruments. But risk traders are not risk absorbers. In times of rising volatility, constraints to their knowledge and capital mean they adhere closely to risk management models, which tell them to sell what is falling most. They follow the herd and become it.

The ratings agencies retort that they cannot be blamed for the way ratings are used. I have sympathy with this, although it reminds me of what the gun manufacturers say after each mass shooting in the US. What puts the smoking gun in the hand of ratings agencies, according to many, is the business model. When markets are under stress, investors question the veracity of ratings. The fact that ratings are paid for by issuers undermines confidence at this critical juncture and contributes to the market freezing up, with dire results.

At first sight the business model appears corrupt. The reality is that a rating is valuable only if everybody knows it, and you cannot get an investor to pay for information he already has. Ratings are a public good. That implies two possible paymasters: government or issuers. Public funding would lead to a public standard-setting (Ms Lagarde is already talking about it) that would stifle insight and innovation. Further, ratings would probably become public guarantees, as investors sought protection from any losses arising from their use of publicly approved ratings. This leaves us with issuers.

The ratings agencies accept that conflicts of interest exist, but claim they have mitigated them through a disclosure of models and ratings. Having tried to conduct a statistical study using ratings, I have not found this transparency as helpful as it sounds. Agencies have responded to requirements for disclosure in the same way as fund managers: by overloading the market with differentiated product, making comparisons hard. Some investors did not know what the rating on their instruments implied.

The wrong direction out of this quagmire would be for regulators to tell agencies how to rate a credit (and then to use these ratings to regulate banks in a dangerous circularity). But regulators could require the industry to standardise what ratings mean, instead of every ratings agency having its own complicated nomenclature. Another step would be for regulators to alter the system that incentivises banks and others, which have natural advantages at hedging and holding credit risks, from transferring them to traders, which do not. This would crimp the originate, rate and relocate model, but it would improve systemic liquidity.