Thursday, September 30, 2010

Credit Rating Agencies In The Spotlight

The IMF says that markets should reduce their reliance on credit ratings (excerpts, emphasis added):

Reducing Role of Credit Ratings Would Aid Markets
By John Kiff

New IMF analysis says that ratings have inadvertently contributed to financial instability—in financial markets during the recent global crisis and, more recently, with regard to sovereign debt.

The analysis, in the IMF’s Global Financial Stability Report, recommends that regulators reduce their reliance on credit ratings as much as possible and increase their oversight of the agencies that assign the ratings used in regulations...

...In the case of sovereign debt, the IMF said in the report released September 29, the problem does not lie entirely with the ratings themselves, but with overreliance on ratings by market participants, coupled with deleterious selloffs of securities when they are abruptly downgraded — called “cliff effects.”…

…The major rating agencies—Fitch, Moody’s, and Standard & Poor’s—do not target their ratings to the specific probability that an issuer will default. Instead they seek to provide only relative rankings of credit risk—that issuers in a lower grade are more likely to default than those in a higher grade and less likely than those below it.

The IMF report finds that the rating agencies do a pretty good job meeting that goal...

...The rating agencies also aim to ensure that ratings do not change frequently, because users prefer to avoid the costs associated with frequent policy changes and investment decisions linked to ratings. The rating agencies minimize ratings changes by judging an entity’s ability to survive a cyclical economic trough (that is, “through the cycle”) and by additionally applying various rating-change smoothing rules.

But the IMF report says that these added smoothing techniques often have an opposite effect from what was intended. Typical smoothing rules sometimes merely delay inevitable downgrades that become more abrupt and cliff-like if the situation has continued to deteriorate...

...To reduce the potential cliff effects in spreads and prices that rating changes can trigger, the IMF recommends the elimination of regulations that formally link buy or sell decisions to ratings, as some countries already have done. The IMF report also says that cliff effects could be mitigated if rating agencies refrained from using smoothing rules that effectively delay rating changes.

Reducing rating overreliance will require better fundamental credit analysis by users, and it will be important that the authorities remain wary of unintended adverse consequences. Moreover, policymakers pushing to reduce rating reliance should recognize that smaller and less sophisticated investors and institutions will continue to use ratings extensively...

...Under the issuer-pay model, there are incentives for the issuer to shop for the highest rating. Although rating agencies want to maintain their reputation for producing accurate ratings, these are diluted by their certification role that has created a more or less “guaranteed” market for their ratings. However, the report concludes that reducing rating overreliance and the associated certification role will go a long way toward reducing the incentives for rating shopping.

There’s no doubt that credit ratings tend to exacerbate market movements, i.e. they are pro-cyclical, helping market players close their eyes to risk when everything is going fine but reinforcing bearishness when markets turn down. Credit rating downgrades certainly helped push the European sovereign debt crisis over the edge, and played a really big role in the collapse of the global interbank market in late 2008.

The big three were also culpable for the nutty ratings on structured asset-based investment products in the pre-crisis era – because of poor transparency of these products, the agencies assigned ratings almost entirely based on models which relied purely on historical data. Since the US housing market had never sustained a big crash since the Great Depression and because the systemic effects of multi-level leveraging of securitisation was not recognised, the ratings appeared well out of line with the riskiness of these securities.

More than that, the issuer-pay model used by ratings agencies worldwide incorporates an inherent conflict of interest – so much so that China is experimenting with an investor-pay model. But it’s unclear if an investor-pay model would work in the long term without some changes to the structure of how the market for ratings functions, since free-riding caused the downfall of the investor-pay model in the 1970s.

I’m reminded of two articles that appeared in VoxEU last year on this same issue (here and here), which identified the complexity of structured finance products as the main reason for ratings-shopping. Both are worth another read for their policy proposals in light of this IMF report.

Malaysia has two ratings agencies (RAM and MARC). BNM, SC and Bursa Malaysia better be talking to them on how we can learn from the West’s experience and incorporate those lessons in the local capital markets, especially with the burgeoning domestic issuance for Islamic finance.


  1. first step should be to enforce "effective ratings" i.e. the lower of X instead of issuer relying on a single agency for its rating..

    The discretionary powers and inherent conflict of interest between rating agency is another issue one must tackle...take the KL market for example ...most issuers are actually advised on how to structure their deals to get a particular rating by the analyst...ini belum masuk cerita kick backs lagi.....

    on the recommendation to remove regulations that link buy/sell....parah tu....most countries have minimum investment guidelines to facilitate prudential requirements on institutional IMF implying that all of this be removed? kasi campak laut la BASLE and all the IOSCO minimum capital guidelines...

  2. I remember my ex-CEO calling MARC to the carpet when they gave us a downgrade - hard to say no to a paying customer, right?

    But I like a few of the proposals from the VoxEU articles, like having the exchanges pay for ratings rather than issuers (paid for by levy? tax on market trades?), which gets around both conflict of interest and free-rider problems.

  3. Now as reported the IMF is finally admitting "Policy makers should work towards the elimination of rules and regulation that hard wire buy or sell decisions to ratings"
    That is good, better late than never. But the real question that needs an answer is why on earth it had to take a financial crisis of monstrous proportions to reach a conclusion that should have been apparent to any regulator from the very beginning.
    Credit reporting agencies