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Who needs credit ratings? They should be optional

Imagine if we all needed our very own personality rating. People would demand to see it even before doing coffee. You would routinely pay a company with emotional expertise to rate you from AAA (superlatively loyal and discreet) to BBB- (tolerable), right down to CCC (total bitch). A higher rating would snare you a bigger pool of potential friends.

This ridiculous arrangement would only last if governments could enforce it. Character analysis is best performed bilaterally; individuals have the most incentive to get it right.

Finance should work like this too. Banks and investors should thrive or die by the quality of their own assessments of credit risk. They have the most incentive to get it right.

But for decades government regulators, through the Basel II bank regulations to take one example, have in effect required all companies and countries to have credit ratings that indicate how likely a particular entity is to default. For regulators, ratings are a simple and cheap way to monitor and compare the riskiness of financial institutions.

The world’s largest rating agencies, which enjoy regulatory clout, Standard & Poor’s, Moody’s and Fitch, have grown fat and powerful on the back of these mandates. They now underpin the world’s financial system; their ratings critically influence the composition of every bank’s balance sheet.

If only the ratings were any good: Bear Stearns and Lehman Brothers were “investment grade” only days before they collapsed. Greece was recently rated A.  Amazingly, before 2008 US sub-prime mortgages were packaged up and sold in AAA-rated securities, facilitating the spread and popularity of sub-prime mortgages throughout the world’s financial system.

And poor ratings are not only a North Atlantic or recent problem — Enron, WorldCom and Australia’s very own HIH Insurance were all “investment grade” before they collapsed in the early 2000s.

Perhaps it is no surprise these credit ratings have been crap. The agencies rarely disagree with each other, they are paid exclusively by borrowers who hanker for higher ratings, their regulatory sinecure protects them from any competition, and as mere opinions, they cannot be held legally accountable for stuffing up.

The proliferation of ratings has absolved banks and investors from having to think carefully about credit risk. Yet credit assessment is meant to be the primary skill of banks. One wonders what the massive army of highly trained and paid financial “risk management professionals” were doing in the lead-up to the global financial crisis. Surely not helping game, to the bank’s advantage, the arcane rules of Basel II?

Moreover, being able to contract out expensive and time-consuming analysis of credit risk has helped banks become huge and hold assets they don’t fully understand.

Following such embarrassing stuff-ups, regulators in Europe and America are now considering regulation of rating agencies themselves. But this will only undermine the quality of ratings even further — agencies will come to capture regulators as much as large financial institutions have. And the incentives for banks and investors to think for themselves will dwindle even further.

The insidious nexus between bureaucrats and rating agencies needs to be broken. Credit ratings and agencies should be excised from every government regulation everywhere.

Credit rating agencies may still thrive independent of regulatory fiat. Individual investors, less skilled in credit analysis and without adequate information, might want to pay for a second opinion, for example.

But governments should set an example and agree to stop paying agencies for a credit rating. Australia could issue a few bonds without one and see what happens. Governments’ accounts, their economic circumstances and history are already widely published. You didn’t need Moody’s to tell you Greece is a bad credit risk and has borrowed too much, or Standard & Poor’s that the US’s credit position has deteriorated.

To be sure, without shorthand credit ratings it will be harder to regulate and constrain banks. But that only matters if governments are implicitly standing ready to absorb banks’ losses. And regulators could still talk to individual banks about how they monitor their own assets.

The No.1 priority for regulators and politicians everywhere should be to destroy entirely the implicit guarantee the finance sector has enjoyed for many years. That will mean tough decisions: perhaps breaking up banks, or bestowing limited liability on businesses only when it is clearly in the public interest, for instance.

The finance sector is and has been, overwhelmingly, the most regulated sector of the economy, the most replete with moral hazard and chock full of malign incentives. And it is the sector that has wrought such damage on the economy. Making credit ratings optional would be a sensible way to help cure these perversions.

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  • 1
    phil@seacliffconsulting.com.au
    Posted Tuesday, 23 August 2011 at 1:39 pm | Permalink

    Thank you Adam for looking under the bonnet of the agency ratings dilemma. Having previously managed a global financial research team (responsible for $40bn of credit rating assessments) for a major investment manager, I can tell a couple of industry truths:
    - most investment managers rely on agency ratings, rather than using them as an initial ‘guide’ and doing their own in-depth analysis
    - the primary reason is that it is expensive to hire enough people to do the in-depth work yourself
    - investment managers should be hiring more people to do it but their customers, such as superannuation funds, usually do not ascribe value to extra research skills and will judge mandates on price rather than quality.

    The core message: agency ratings do help facilitate business, but should not be relied upon. Caveat emptor.

    Phil Preston

  • 2
    JLG
    Posted Tuesday, 23 August 2011 at 6:04 pm | Permalink

    Can’t argue the point that investors need to due their due diligence, but Adam, you need to check your facts also. By and large, the agencies give unsolicited ratings for sovereigns, meaning that they’re not paid for.

  • 3
    Posted Tuesday, 23 August 2011 at 6:58 pm | Permalink

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