The Role Of Credit Ratings: No Replacement On The Horizon

Credit rating agencies aren’t perfect – in fact, far from it. Ratings can sometimes (often?) be inaccurate guides to the potential for debt defaults, and the consistency and integrity of ratings can and have been questioned. The business model used by most credit rating agencies globally, where debt issuers pay for ratings on their own debt, is subject to potentially considerable conflicts of interest.

Unfortunately, attempts to find a replacement have come up with alternatives that are even worse (abstract):

Replacing Ratings
Bo Becker, Marcus Opp

Since the financial crisis, replacing ratings has been a key item on the regulatory agenda. We examine a unique change in how capital requirements are assigned to insurance holdings of mortgage-backed securities. The change replaced credit ratings with regulator-paid risk assessments by Pimco and BlackRock. We find no evidence for exploitation of the new system for trading purposes by the providers of the credit risk measure. However, replacing ratings has led to significant reductions in aggregate capital requirements: By 2012, equity capital requirements for structured securities were at $3.73bn compared to of $19.36bn if the old system had been maintained. These savings reflect the new measures of risk, and new rules allowing companies to economize on capital charges if assets are held below par. These book-value adjustments dilute the predictive power of the underlying risk measures, Our results are consistent with a regulatory change being largely driven by industry interests rather than maintaining financial stability.

Somehow, getting fund managers and private equity firms to do portfolio risk assessments strikes me as a little bit like putting the fox in charge of the hen house.

Driven by “industry interests”, indeed.

Technical Notes

Bo Becker, Marcus Opp, "Replacing Ratings", NBER Working Paper No. 19257, July 2013