Lambert here: This is the third part in a three-part series on how to fix what is wrong with credit rating agencies. Please see part 1 here, and part 2 here.
By Susan Schroeder, a lecturer in the Department of Political Economy, University of Sydney, Australia, and author of Public Credit Rating Agencies: Increasing Capital Investment and Lending Stability in Volatile Markets (Palgrave Macmillan, 2015). Originally published in the July/August 2016 issue of Dollars & Sense magazine; cross posted from Triple Crisis.
The beauty of mainstream economics, which assumes the inherent stability of markets, is that, if markets work well, the public interest aligns with the interests of private agents. In this view, then, the key policy objective is to improve the efficiency of markets. But if markets are inherently unstable, the interests do not align. In this context, increased government presence to promote a more stable economy and financial system is what promotes the public interest.
A Minskian basis for credit risk-assessment and a public credit-rating agency would be a good start, but they will not be enough to thwart the ups and downs in ratings over the course of the business cycle. To do this requires reducing the cyclical patterns of the economy as a whole. This will likely require an industrial policy focused on civilian industries that promotes the sale of output by firms (often referred to as “supply support” or “demand management”). One way to facilitate the absorption of some firms’ output by other firms is to create an insurance scheme to protect the accounts receivable of firms from the risk of non-repayment, focusing particularly on small and medium-sized firms as their failure rate is higher than for corporations. That way, if one firm owes another one money, but does not pay on time, the latter firm does not find itself short on cash to meet its own obligations. (That is, one firm’s default on its debts does not set off a chain reaction.) The “trade credit insurance” enjoyed by export banks is a precedent for this kind of scheme. Stabilizing their cash inflows strengthens their ability to absorb goods and services from other firms and to employ workers. With this mechanism in place, banks will be more willing to supply short-term financing during bouts of instability. Living wages that reduce consumers’ reliance on credit would also reduce debt-service burdens and support consumption. Robust consumption and strong cash-flow for firms, in turn, stimulates investment.
When models of the market economy and credit assessment better reflect the inherent instability of a market economy, policy options widen dramatically. For instance, living wages may not be inflationary, as conservative pundits suggest, and industrial policies may be better than free markets for promoting economic development and social goals.
Unfortunately, neither of the Democratic candidates for president appears to offer convincing policy recommendations for the ratings industry. Former Secretary of State Hillary Clinton prefers the status quo, under which standards of due diligence and development of credit risk models remain squarely at the discretion of rating agencies and financial institutions. Of even more of concern is the signal Clinton seems to send, intentional or not, that her administration may be willingly captured by financial interests.
Sen. Bernie Sanders, on the other hand, at least addressed the problems with the issuer-pays model, which promotes borrowers “shopping” for favorable ratings. Sanders suggests creating non-profit agencies that generate ratings for issuers and instruments. (This is not a new idea. The Bertelmann Foundation, for instance, has been promoting the creation of an international non-profit rating agency.) There are two unresolved issues with this approach. First, who pays for the ratings to be created? Second, who is ultimately accountable for the ratings issued? Likewise, a government agency that allows itself to be accountable, directly (by creating ratings itself) or indirectly (by being responsible for assigning that task), could find itself litigated to death when an economy turns sour.
Like Clinton, however, Sanders misses the key point. The source of the problems with ratings is not the rating agencies’ behavior or the issuer-pays model per se. Rating firms have only so much leeway in inflating ratings. While Sanders’ suggestion might be able to achieve better uniformity of opinion, it cannot thwart the natural swings in creditworthiness over the course of the business cycle. The ultimate source of the problem is the inherent instability of a market economy itself.
Stabilizing creditworthiness requires new thinking on how, as Minsky put it, to “stabilize an unstable economy.” That means an industrial policy, not just for a single nation, but for a system of many nations embedded in a global economy. In combination with a living wage, such an industrial policy would go a long way towards putting the U.S. and world economies back on track—boosting supply support for firms within targeted industries and bolstering income growth for consumers. Programs that facilitate the absorption of firms’ output protect the incomes of workers which, in turn, reinforces the demand for output. A new international system could also go so far as to enhance coordinated efforts to fight climate change by encouraging development of industries associated with renewable energy and reforestation.
When it comes down to it, credit rating agencies are important. If they disappear, either through legislation or litigation, what would take their place? A public rating agency could facilitate the development of better products in the credit rating industry. Leaving the development to private agencies, or “to the markets,” is not likely to work, as history has shown. Private credit rating agencies are more apt to maintain unrealistic assumptions to facilitate speed of assessments rather than develop more accurate assessments. More accurate methods require time and funding, and this is where government can be of assistance. It is in the public interest to do so.
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One has to wonder why mainstream economists even gave so called ratings agencies the time of day… when the much vaulted EMH theory would not necessitate a middleman or bottleneck for information clearing…
Disheveled Marsupial… seems contrary to every fundamental aspect of the philosophic bent and …. metaphysical truisms (laws ™…
Because their paymasters willed it.
As someone who manages credit portfolios for a living, I would suggest that the thought that some government supported central ratings agency would add any value is absurd. One need only look at the army of PhD economists employed by the Federal Reserve and their abysmal track record on forecasting the economy to see that more, “better” resources often add no insights whatsoever. People seem to be under the naive impression that investors blindly accept the determinations of the ratings agencies, without any critical thinking. Investors know the shortcomings of ratings agencies better than most, and try to act appropriately. Like equity investing, credit investing is a skill, and some will be better than others, leading to different results among managers. This will not change even if we had “better” ratings.
One problem, however, is when regulated entities such as banks are forced to use public ratings to manage their portfolios. A manager may well know that a given rating is not appropriate, but is forced to live within the constraints dictated by the rating. I may believe that a BB- issue is a better credit than some AAA structured product, but I could be restricted from investing accordingly. Indeed, the market often knows that a lot of “AAA” product is not really “AAA”, but a manager can readily beat his benchmark by investing in these securities as they may trade at higher yields, but don’t really have the safety their rating would suggest.
The biggest risk I see is the ratings on structured products. The difference in performance from a B versus a BB is likely not too dramatic, assuming we are looking at a typical firm. However, once we start looking at structured credits, all bets are off. Ratings agencies employ simplistic data analysis, with limited data, as well as naive and unrealistic assumptions regarding past performance versus expected future performance. Not sure if there is any easy answer here, but given the huge potential for large tail risks, this is one area which might benefit from better analysis and the dedication of resources beyond the existing ratings agencies.
I think it’s a good idea that government agency that helps the rating industry to conduct due diligence and facilitate the development of more accurate ratings. Both of these activities are expensive, and I think this stymies the development of credit risk assessment. Government can be helpful here. I understand that practitioners, managers and policy-makers are frustrated with the ratings’ shortcomings.
The reference to economists employed by the Fed seems to reflect the similarity of economics degree programs. Analysts/economists are not trained to think outside the limits of closed systems of economic analysis. A concern I have is that the increased reliance on “big data”, and the quantitative methods to draw out patterns, is going to further marginalize the importance of experts in the assessment process. What I see are engineers and accountants being called in to handle and assess “big data”. Perhaps you see something different?
The book does not argue that regulated entities should be forced to use any system created by a public credit rating agency. It puts forth ideas on how to improve the ratings products. The book makes this clear; perhaps, the article needed to draw that out more clearly. (There’s only so much of the book that can do into that article.) The comment about structured products seems to agree with the book in that there needs to be an entity that facilitates improvements.
What, as many suspect, if markets are actually chaotic?
The opening sentence is not quite so beautiful.
If andy only if, the markets are rhythmic, not chaotic.
Another insurance bezzel, which increases cost, couple with payment avoidance fine print.
Assumption not in evidence. An equilibrium requires linear feedback, and every electrical or electronic engineer knows there is no such thing as perfect linear feedback.
The ultimate source of the problem is the chaotic nature of a market economy itself.
There several terse Australian expression which summertime this article. I’m think of one which starts with a ‘w,’ or another which starts “what a load of….”
OK. You hold a vision that a market economy is inherently chaotic. I respect that. I hold a vision that a market economy is inherently unstable, but does generate patterns which help us understand how it behaves. The book presents patterns. If you want more empirical evidence of patterns, then please see the work of Gerard Dumenil and Domenique Levy. Even better, have a look at the new book by Anwar Shaikh (Capitalism: Competition, Conflict and Crises, 2016, Oxford University Press), because it has tons of empirical patterns.
In any case, one cannot disparage another person’s vision. Each of our visions, for instance, has been shaped by our social and political experiences, family, education, and so on. Neither of us has the right to state that the experiences of the other are inferior. What we can do is argue our points, hope to learn and take something away from the experience which makes us better.
Why not just give the ratings agency a stake in the outcome of the loans?
ie – someone defaults on a loan that was given a good rating, the agency takes a hit.
Someone did propose a variant of that idea. Of course, it got nowhere.
Umm…trade credit insurance along the production supply chain already exists. In fact, the risk of GM losing its credit insurance and how that would effect its suppliers was one of the worries behind that auto bailout. On the other hand, a WIR type system for SMEs has much to recommend it, as precisely improving the efficiency of trade credit and the payments between firms, without relying on the formal banking system and its vagaries.
My understanding is trade credit insurance can be purchased from private firms. The book proposes something more systematic,managed by the government, focusing on SMEs. SMEs are less likely to purchase insurance because of cost considerations. The government could help manage the insurance contracts in a way that not only supports SMEs but also promote a shift in industrial configuration towards civilian industries.
A key point here is that if a market economy is inherently unstable, then policies/regulations which promote increased reliance on the free market is going to be counterproductive for creating a more stable economy and financial system.