How Credible are the Credit Rating Agencies?
With the ‘big three’ in an enormous position of power, it is time to regulate the ratign agencies effectively.
PROF. JOHN RYAN | DECEMBER 12, 2012
The reputational crisis of credit rating agencies is ongoing and is putting into question whether CRAs are playing a credible role in eurozone financial markets. The single currency crisis supports the proposition of scepticism on the credibility of CRAs, which did not properly disclose risks and therefore contributed to pushing the global financial system to the verge of collapse. Politicians across the European Union have called for restrictions on the role of CRAs in rating sovereign debt and for increased regulation of the firms. In the United States, the credit rating agencies hide behind the First Amendment. Their legal argument is that they cannot be held accountable because they are merely issuing “opinions”. The European Commission released an impact assessment with proposals on November 15, 2011, that would give supervisory authorities the power to temporarily prevent the issuing of ratings on countries in “a crisis situation”. This would also provide investors with a framework to take legal action against agencies, if they infringe intentionally or with gross negligence on their obligations.
The financial and eurozone crisis has drawn considerable attention to the role of CRAs in the financial system. The rating agencies were criticised after the banking collapse in 2008 – for the failure of rating correctly certain financial products, contributing to the severity of the collapse. With their reputations yet to recover, they have now been accused of precipitating and exacerbating the eurozone crisis by downgrading the sovereign ratings of Greece, Ireland and Portugal too far and too fast. Politicians across the EU have called for increased regulation and suggested that the oligopoly of the three major rating agencies should be challenged by the creation of a European credit rating agency. The valid charge against the rating agencies is that they failed to challenge the assumptions upon which their assessment of the sustainability of sovereign debt was based in the years running up to the crisis. And so they failed to identify risks in some single currency states, which began building long before the crisis hit.
Even before the financial crisis, CRAs were already coming under close scrutiny. Public authorities were acutely aware of the pivotal and deepening role played by rating agencies in the financial system and had observed several apparent failings. In particular, rating agencies had been criticised for their slow response to the strains that ultimately gave rise to the Asian crisis in 1997 and 1998, and the high-profile corporate failures of Enron, WorldCom and Parmalat. Experience during the financial crisis has also heightened concerns that rating agencies’ decisions may be subject to conflicts of interest. Since rating agency revenues are predominantly driven by rating fees earned from issuers, there is a concern that CRAs devote disproportionate resources to chasing new business and rating new products – rather than on improving their analysis of existing instruments. Furthermore, the revenue incentives of a CRA are such that ratings may be biased upwards – inflated – so as to meet an issuer’s expectations and thereby gain or keep their business.
The operational rigour of the CRAs is also in question. Standard & Poor’s caused the latest controversy with its erroneous downgrade of France. The agency’s email went out on November 10, 2011, just before 4pm Paris time when the European markets were still open. Its “opinion” thrust a knife into “containment”. The yield for France’s 10-year bond jumped 25 basis points to 3.48 per cent and the spread between 10-year French and German bonds hit 1.7 per cent – a euro-era record. S&P’s waited two hours to issue a correction, after the European markets had closed.
On December 5, 2011, S&P’s put 15 eurozone member states onto negative credit watch, a move which normally means that there is a 50 per cent chance of a credit rating downgrade within 90 days. And S&P suggested that all non-AAA rated countries together with France could be subject to a two notch downgrade. The agency said the move was “prompted by the belief that systemic stresses in the single currency had risen in recent weeks to the extent that they put downward pressure on the credit standing of the eurozone as a whole”. On December 6, 2011, S&P’s then put the eurozone’s rescue fund, the European Financial Stability Facility, on watch. Those placed on “negative credit watch” included all of the currency union’s remaining triple AAA rated sovereigns: Germany, France, Austria, Finland, the Netherlands and Luxembourg. And S&P cited rising “systemic stress” due to an “approaching recession”, a dysfunctional political process and a bank credit crunch, with the agency estimating that banks would see €205bn of their debt mature in the first quarter of next year.
There is a need to strengthen the accuracy of credit ratings and reduce systemic risk. First, there is a need for a regulatory authority to rank them in terms of performance; in particular, the accuracy of their ratings. Second, regulatory authority need to facilitate the ability of investors to hold credit rating agencies accountable in civil lawsuits for inflated credit ratings, when a credit rating agency knowingly or recklessly fails to conduct a reasonable investigation of the rated security. Third, regulatory authorities need to ensure credit rating agencies institute internal controls, credit rating methodologies and employee conflict of interest safeguards that advance rating accuracy. Fourth, the regulators should use their inspection, examination and regulatory authority to ensure credit rating agencies assign higher risk to financial instruments whose performance cannot be reliably predicted due to their novelty or complexity or that rely on assets from parties with a record for issuing poor quality assets. Finally, regulators should reduce a government’s reliance on privately issued credit ratings.
This articles first published at PublicServiceEurope.com