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12/08/2011

Rating agencies: thermometers or detonators of the crisis

At the heart of the debate in these times of relentless crisis are the rating agencies, ubiquitous in the news and subject of many comments in such a way that the feasibility of the current rating system is questioned.

Introduction to the ratings system

The main activity of rating agencies is to provide regular advice on credit quality and the ability to meet the financial obligations of an issuer or a financial instrument through a rating (ratings are specific to each agency). These ratings, based on income flows, balance sheet structure and financial performance of the rated entity, classify issuers into categories of default risk (high risk, "speculative grade", low risk, "investment grade"). Additionally some agencies have other financial activities such as investment advice.

This principle of ratings and the surrounding system was born in the United States. In the mid-19th century, following a panic in the financial markets in 1837, the need to assess the creditworthiness of companies becomes necessary. Particularly, there was a need to reassure investors not to restrain the development of railroads that used the bond market.
In 1841 The Mercantile Agency was founded, the first company for financial analysis of credit.
Throughout crises and bankruptcy, the activity of rating agencies structured itself, changed (analysis of short-term debt plus long-term debt), found itself more and more regulated by the SEC and its financial laws in the 70's (creation of the NRSRO status without which no credit rating agency can operate in the U.S.) and saw their activities internationalize.

The creation of agencies, their development and internationalization is the result of the will of all market participants (regulators, borrowers, issuers of debt ...) in order to support and accelerate the movement of intermediation.
The introduction of rating agencies in the Basel II regulatory reforms has only strengthened the power of rating agencies by giving them quasi-regulatory power.
In this context, the so-called "standard" method allows banks to use the ratings of agencies, provided they are licensed ("external credit assessment institutions" (ECAIs)) to determine the appropriate level of capital. This approval, which is difficult to obtain as to guarantee the Basel II accord, is based on the criteria of objectivity, independence (agencies cannot be public institutions nor can they have banks as shareholder), transparency (public information) and requires a level of resources (financial or human) sufficient to carry out their missions.
During the Basel II discussions, in which agencies did not participate, the agencies themselves were opposed to their "industrialization" which could only be addressed by more regulation.

Some agencies specialize in certain markets. There is, for example, Canadian Bond Rating Service, ICRA (Investment Information and Credit Rating Agency of India), MicroRate (micro-credit rating). A total of 150 financial rating agencies were listed worldwide in 2010 but few of them have a global reach: 7 in 1975, but only 3 in 2004 dubbed as "The Big Three":

The limits of the present system

With transparency and independence of evaluation being a major issue for financial markets, many critics have emerged in the wake of recent crises: Enron, subprime, crisis in Greece ...
For example, some observers note that the three major agencies have methods to the detriment of European law in regard to Anglo Saxon law which raises competition concerns since advantages may exist depending on the legal system in which the valued institute is operating.
More generally the system is seen as opaque. The argument most often put forward is the funding of the assessor by the evaluated (private institutions pay to be rated but the service is free to sovereign states); clearly a source of potential conflicts of interest. In contrast to the rating of a corporate bond, there is increased risk in rating structured products, for which the rating is calculated a priori: the agency proceeds with the investment bank in the process of structuring the loan. In other words the agency is a consultant and evaluator. This type of conflict of interest is inevitable once the structured credit is made by agreement and not on an organized market.

In addition, this type of operation is the subject of specific contracts written by a handful of specialized law firms. Agencies are therefore working with the same law firms on various operations, which can also be a source of conflict of interest. The lack of transparency regarding the methodology used by the three major agencies (especially in the creational process of ratings) is also pointed at, especially the non-systematic character and the few procedures of the methods used. This remark is especially true in securitization: the dialogue between issuers and leading agencies in the calculation procedure of the final note may seem distorted, with agencies relying primarily on the legal advice of the issuers that also remunerate the agencies.

The repetition of crises has never been so important on the disintermediated market since the emergence of these organizations, which are supposed to anticipate and guide investors. This paradox is fueling the debate on their responsibility. For example, during the subprime mortgage crisis, rating agencies have been criticized for their failure to asses the risk of structured products properly. This crisis highlighted the fact that the evaluation of these products appeared to be structurally inefficient: many agencies evaluated the structured products in question, but treated them as if they were independent pools of credit each having a low risk. These products were actually backed by a common risk (real estate), when interest rates rose and housing prices fell, all subprime products reacted in a homogeneous way and their value decreased leading to a liquidity crisis in the banking system.
The core problem of pricing models, which calculate macro-economic risk factors badly, became obvious. Notwithstanding this, the agencies appeared to be the financial players with the fewest malfunctions during the crisis. More flagrant errors were made by other stakeholders (regulators, issuers of credit, resecuritization...). Especially since it was a liquidity crisis and that the assessment of liquidity risk is not within their prerogative.

Another example: rating agencies were criticized for maintaining a good credit rating for Enron until four days before its bankruptcy, which raised questions on their independence. During the recent Greek debt crisis, their role in fuelling speculation in financial markets was denounced by political leaders.

Beyond the real or perceived responsibility of rating agencies in the successive crises is the lack of legal liability that seems to be the final argument of opponents of the current system. The current status of rating agencies does not allow public authorities to impose any administrative sanction; this is the case for both the SEC in the United States or regulators in Europe. This lack of sanctioning makes any type of control inefficient and renders any questioning of the activities of rating agencies almost useless.

Towards a new ratings system

The growing criticism and questioning on the current ratings system resulted in a global reflection, some advocating better regulation of the current system, others its overhaul.
In terms of regulation French President Sarkozy and German Chancellor Merkel have written a joint statement on September 10th, 2007 to better supervise the rating agencies. The idea is to frame their methodology rather than their status or number. The main area for improvement that comes up most often is to tighten the rules on conflict of interest so that the agencies don't find themselves in a position of judge and jury.
Moreover, the idea of imposing more demanding standards for the control of the information provided to credit rating agencies has also emerged. Another area of improvement concerns the central banks, who could alert when the price of an asset would obviously become irrational (the major markets have long historical data that are able to calculate the fundamental long-term values).
The monitoring of agencies by market authorities, which is the case in the United States since 2006 (Credit Rating Agency Reform Act), is also drawing interest from the European Union. Several proposals relate specifically to the securitization process and are primarily intended to allow greater transparency of rating methods and the exact role of agencies in this context. For example, the idea surfaced of a marked differentiation between metrics of bond ratings and structured ratings by adopting a specific rating scale for structured products or by completing the existing rating with a measure of volatility in times of market stress or liquidity stress.
This way, agencies themselves are considering the establishment of a specific rating for liquidity risk, despite the difficulty of the exercise. The question of the business model of agencies is also an element of reflection that is based on two key issues: the status of analysts and changing the principle of "the assessed pays."

With regard to the status of credit analysts in agencies, a professionalization could take place which would result in more accountability. However, it is difficult to distinguish between credit analysts solely on the grounds that they are employed by rating agencies.

The reflections on the abandonment of "the assessed pays" led to two ideas:

  • Either, investors would pay to know the rating of a specific company (which would de facto remove the public nature of the notes)
  • Or agencies become a public service in which investors pay a fee for a service they would be forced to accept (agencies would work under the supervision of an authority that could impose its methods and means).

Regarding the last point the idea of creating a European rating agency has been mentioned in the spring of 2011 by the leader of the finance ministers of the euro zone Jean-Claude Juncker. The main argument being that such an agency would provide "a basic understanding" of economic mechanisms, different from the existing agencies, more oriented towards "sustainability" of the economy and less to short term.

Some economists are opposed to excessive regulation of the system which would lead to less accountability of all players while the risk of error is always present, but prefer the idea of restoring responsibility to banks and investors to assess counterparts or credits contracted for.
For these players, there will be more regulation and with a rising risk of a ratings downgrade there will be no safeguard for their reputation. In addition, if the method is standardized any error in the method will be generalized. The problem is not so much the rating but the way it was used by both regulators and market participants (banks, investors ...), transforming a simple opinion meant to improve decision-making in a quasi-certification.

Sia Partners

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