Monday, March 31, 2014

Regulation And Ratings

There’s a fascinating new working paper at the NBER that examines how the confluence of ratings and regulation conspired to help create the 2008-2009 global financial crisis (abstract):

Rating Agencies
Harold Cole, Thomas F. Cooley

For decades credit rating agencies were viewed as trusted arbiters of creditworthiness and their ratings as important tools for managing risk. The common narrative is that the value of ratings was compromised by the evolution of the industry to a form where issuers pay for ratings. In this paper we show how credit ratings have value in equilibrium and how reputation insures that, in equilibrium, ratings will reflect sound assessments of credit worthiness. There will always be an information distortion because of the fact that purchasers of ratings need not reveal them. We argue that regulatory reliance on ratings and the increasing importance of risk-weighted capital in prudential regulation have more likely contributed to distorted ratings than the matter of who pays for them. In this respect, much of the regulatory obsession with the conflict created by issuers paying for ratings is a distraction.

Skipping over the math, what Cole & Cooley observe is that credit ratings and rating agencies continue to function pretty well, even under the potential conflict of interest arising from the “issuers pay” model, at least for “vanilla” credit securities.

But the use of ratings under regulation has a much more pernicious impact. Since financial intermediaries (e.g. banks, insurance companies) are required by regulators to support a certain standard of quality in the assets they hold (which are defined by ratings), that artificially increases demand for investment grade or riskless assets. Off the top of my head (it’s not in the paper), a couple of implications stand out to me here:

  1. The yield of investment grade and risk-free government debt would be lower than it would be without the regulatory-defined fault line. Or in other words, debt is priced too cheap for investment grade debt and too expensive for non-investment grade debt, relative to their actual risk;
  2. Demand for risk-free and investment grade debt would also be relatively inelastic, which makes the market distortion under implication 1 even worse.

More to the point, what the authors have outlined also implies a compelling argument for maintaining a steady supply of government securities into the debt markets, irrespective of fiscal conditions.

In the late 1990s, the United States suffered a rare occurrence – a fiscal surplus – that caused a sharp drop-off in the issuance of US Treasuries. This happened to coincide with a marked reduction in the issuance of top grade corporate debt, as solid economic growth and productivity in the 1990s allowed big firms to finance their investment via internally generated funds.

The upshot of it all was a shortage of “safe” assets that financial intermediaries desired to hold or swap as collateral, which bolstered the demand for private sector alternatives to government securities and AAA corporate debt.

Enter stage right: mortgage backed securities and collateralised debt obligations. Cue monologue on the dangers of unintended consequences.

This isn’t to say that the major rating agencies (S&P, Moody’s, Fitch et al) did not carry any responsibility for the crisis. Ratings “shopping” was certainly a factor, as was rating-by-model. But the regulatory environment, and supply and demand for investment grade assets, was probably as much to blame – there wouldn’t have been such a demand for CDOs if there wasn’t a market gap that needed to be filled.

So tell me again: why are we trying to balance the fiscal budget in Malaysia?

Anyone in the local debt market knows that top grade corporate debt issuance isn’t exactly a waterfall; and Cagamas doesn’t come near to filling market needs (nor do we want to go down that route). A secular reduction in government borrowing will constrict the development and stability of both the debt markets and financial system. BNM securities are both safe and plentiful, but have very short tenures.

So even if fiscal consolidation is a meaningful and worthwhile goal, we might have to go the Singapore route – strange as it may seem, the government might have to keep borrowing money, even after the books are balanced.

Technical Notes

Cole, Harold & Thomas F. Cooley, "Rating Agencies", NBER Working Paper No. 19972, March 2014


  1. There's something a bit odd about this post.

    It seems like you're saying that fiscal consolidation will hurt our capital market development because there's fewer Gov't debt papers to go around.

    Assuming we go the Singapore route, our Gov't's relative cost of debt (vs. say revenue) makes this a little bit difficult. And despite the need for the capital market to develop, wouldn't the excess supply theoretically soak up liquidity meant for other domestic assets (i'd say crowding out, but the corporate bond mkt is a bit docile)?

    I'd personally would aim for something more neutral...say for the Government to target for a long-run primary balance instead of fiscal surplus. That way we can (err.... 'maybe') achieve both of aims.

    1. Jason,

      I'd be less concerned about capital market development, and more concerned with financial system stability.

      Also, I don't think I'd be too concerned if we "followed" the SG model. Raising debt in excess of requirements serves the exact same purpose as an issuance of central bank liabilities - it does soak up excess liquidity, and moreover it will be "backed" by cash. The only difference (from an investor perspective) is the maturity profile. So, given the existing excess of BNM bills on the market, this will mainly be about displacing one liability with a similar, but longer tenured one.

      Yes, a fiscal policy rule based on primary budget balance would fit the bill, though I don't think this will serve enough safe securities to the financial system. Debt service is only about 2% of GDP right now, relative to average bank asset growth of 8%. Banks appear to be wanting to hold a minimum of 2% of assets in govt securities (the ratio doubled during the GFC as you might imagine, but fell back slowly thereafter). So as time passes, the availability of MGS and GII will progressively tighten under such a fiscal rule (i.e. yields should fall, relatively speaking).

      I'm curious to know, do you agree with the hypothesis that regulatory use of ratings leads to mispricing of credit?