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THE recent downgrade of South African banks by Moody’s (and the Reserve Bank’s surprisingly sharp response) has once again turned the spotlight on the role of credit rating agencies (CRAs) in the economy.
While they do have at least some influence on the cost of capital and its allocation and consequently on economic efficiency, the question should be asked whether we are not overemphasising their importance.
Credit ratings are used extensively by investors as well as regulators in their decision making, so much so that they are deemed to have been hardwired into a wide range of regulatory and investment processes. According to Lawrence White, regulation has artificially increased the demand for ratings while restricting the supply by only accepting ratings from officially recognised CRAs.
In 2011 the Bank of England expressed the view that “CRAs can no longer be regarded solely as the providers of private goods to private markets. The crisis has demonstrated clearly that the public policy consequences of CRAs’ franchises need to be taken into account.”
The so-called Joint Forum (consisting of the Basel Committee on Banking Supervision, the International Organisation of Securities Commissions and the International Association of Insurance Supervisors) has listed five key purposes of credit ratings:
- determining capital requirements in banking and insurance, inter alia in terms of the successive Basel frameworks for banking supervision (using credit ratings only from officially recognised CRAs);
- identifying or classifying assets, e g the designation of permissible investments and setting investment concentration limits;
- providing an evaluation of credit risk in securitisations and covered bond offers;
- determining disclosure requirements for rated entities; and
- governing prospectuses for security offerings.
In theory, CRAs can make an important contribution to addressing information asymmetries and reducing uncertainty in financial markets. Reducing uncertainty should result in lower risk premiums and thus lower borrowing costs for issuers.
However, a number of issues relating to how CRAs fulfil this function have been raised.
Are rating agencies independent?
Firstly, the independence of CRAs has been questioned because they are being paid for their services by the issuers of securities, which could result in too generous ratings in order to facilitate the conclusion of future business. A counter-argument is that reputation risk will work against any bias CRAs may have in this regard.
Secondly, CRAs have been accused of often being slow to adjust ratings in a timely fashion, viz adjusting credit ratings only after a major event and then overreacting to compensate for the lack of timely action. (For example, at the time of the demise of African Bank it enjoyed an A-rating from Moody’s.)
This could be the result of CRAs fearing that they will be accused of precipitating a crisis, while the users of credit ratings also prefer ratings to be stable to avoid frequent portfolio adjustments because of the cost involved.
CRAs therefore claim that they “rate through the cycle”, providing a long-term perspective, but the question should be asked whether CRAs actually provide useful information in addition to observing the spreads on the relevant bonds in financial markets.
Thirdly, CRAs have been judged to be guilty of pro-cyclical behaviour, thus increasing risk rather than mitigating it and causing greater volatility in markets.
Fourthly, the credit rating industry has been branded as uncompetitive, with the top three CRAs accounting for 95% of the business (see figure below). The way in which credit ratings are being used in fact creates considerable barriers to entry to the credit ratings industry and encourages the perpetuation of the prevailing oligopolistic market structure.
There is therefore a need for greater transparency of credit rating methodologies to strengthen competition and create opportunities for new entrants to differentiate themselves. On the other hand, having fewer CRAs promotes greater uniformity and consistency in ratings, making it easier for investors to compare securities.
Adam Posen of the Peterson Institute for International Economics and a former member of the monetary policy committee of the Bank of England and David Smick went so far as to state that “ratings agencies serve no useful purpose except inherently to mislead investors”, calling for the disenfranchisement of the CRAs.
They ask the interesting question why, if no institution can definitively determine the worth of a stock, it should be true for a fixed-income security.
It is therefore not surprising that the international Financial Stability Board (FSB) has a reduction in reliance on CRAs and increasing oversight of their activities as an objective in order to reduce what it calls “financial stability-threatening herding and cliff effects” from CRA rating changes.
It is the FSB’s purpose to “end mechanistic reliance by market participants (on CRA ratings) and establish stronger internal credit risk assessment practices instead”.
The FSB published a document relating to “Principles for Reducing Reliance on CRA Ratings” in October 2010. This was followed by a more detailed roadmap in November 2012, suggesting specific timelines for steps to be taken in a process that is set to run until 2016.
The last progress report on this at the level of the G20 was lodged in August 2013, but individual countries continue to report on their own progress in this regard (Australia being the most recent one to do so).
The principles are briefly as follows:
- removing CRA ratings from standards, laws and regulations wherever possible;
- encouraging banks, market participants and institutional investors to make their own credit assessments;
- eliminating the use of CRA ratings by central banks and reaching their own credit judgements on financial instruments;
- discouraging the use of CRA ratings in margin agreements; and
- encouraging issuers of securities to disclose comprehensive, timely information (publicly for publicly traded securities) to enable investors to make their own, independent judgements.
In short, although the FSB does not have the complete elimination of CRA ratings as an objective, it certainly aims to relativise CRA ratings by identifying them as mere opinions for which other (better) alternatives are available.
'Up to investor to accept or reject our opinion'
In the few instances where investors have sued rating agencies to compensate them for losses suffered on investments they entered into based on a favourable credit rating that turned out to have been wrong, the ratings agencies themselves have argued as part of their defence that they merely express an opinion and that it is up to the investor to accept or reject that opinion.
Investors who delegate the assessment of risk to rating agencies should therefore remember the caveat emptor rule!
South Africa is also participating in the process initiated by the FSB, although the hardwiring of CRA ratings in regulating the banking sector in particular is mostly through compliance with international frameworks and standards.
The South African Reserve Bank has implemented its own Credit Default Swap model to reduce reliance on CRA ratings and it has moved to prevent inappropriate use of and overreliance on CRAs by financial institutions.
In summary, credit ratings will continue to provide useful although not fully foolproof information, especially to small investors who cannot do their own credit assessments. Perhaps we should just learn not to overreact to the changes in the opinions of CRAs.
References
1. The Joint Forum: Stocktaking on the use of credit ratings. June 2009.
2. Financial Stability Board: Principles for Reducing Reliance on CRA Ratings. 27 October 2010.
3. Financial Stability Board: Road map and workshop for reducing reliance on CRA ratings. 5 November 2012.
4. Financial Stability Report: Credit rating Agencies. Reducing reliance and strengthening oversight. Progress report to the St Petersburg G20 Summit, 29 August 2013.
5. David Smick and Adam Posen: Disenfranchise the Ratings Agencies. The International Economy, Fall 2008.
6. Pragyan Deb, Mark Manning, Gareth Murphy, Adrian Penalver and Aron Toth: Whither the credit ratings industry? Financial Stability Paper No 9. Bank of England, March 2011.
7. Nicolas Véron: Rate Expectations: What can and cannot be done about rating agencies. Brueghel Policy Contribution, October 201 (sic).
- Fin24
*Jac Laubscher is Group Economist of Sanlam. Opinions expressed are his own.
While they do have at least some influence on the cost of capital and its allocation and consequently on economic efficiency, the question should be asked whether we are not overemphasising their importance.
Credit ratings are used extensively by investors as well as regulators in their decision making, so much so that they are deemed to have been hardwired into a wide range of regulatory and investment processes. According to Lawrence White, regulation has artificially increased the demand for ratings while restricting the supply by only accepting ratings from officially recognised CRAs.
In 2011 the Bank of England expressed the view that “CRAs can no longer be regarded solely as the providers of private goods to private markets. The crisis has demonstrated clearly that the public policy consequences of CRAs’ franchises need to be taken into account.”
The so-called Joint Forum (consisting of the Basel Committee on Banking Supervision, the International Organisation of Securities Commissions and the International Association of Insurance Supervisors) has listed five key purposes of credit ratings:
- determining capital requirements in banking and insurance, inter alia in terms of the successive Basel frameworks for banking supervision (using credit ratings only from officially recognised CRAs);
- identifying or classifying assets, e g the designation of permissible investments and setting investment concentration limits;
- providing an evaluation of credit risk in securitisations and covered bond offers;
- determining disclosure requirements for rated entities; and
- governing prospectuses for security offerings.
In theory, CRAs can make an important contribution to addressing information asymmetries and reducing uncertainty in financial markets. Reducing uncertainty should result in lower risk premiums and thus lower borrowing costs for issuers.
However, a number of issues relating to how CRAs fulfil this function have been raised.
Are rating agencies independent?
Firstly, the independence of CRAs has been questioned because they are being paid for their services by the issuers of securities, which could result in too generous ratings in order to facilitate the conclusion of future business. A counter-argument is that reputation risk will work against any bias CRAs may have in this regard.
Secondly, CRAs have been accused of often being slow to adjust ratings in a timely fashion, viz adjusting credit ratings only after a major event and then overreacting to compensate for the lack of timely action. (For example, at the time of the demise of African Bank it enjoyed an A-rating from Moody’s.)
This could be the result of CRAs fearing that they will be accused of precipitating a crisis, while the users of credit ratings also prefer ratings to be stable to avoid frequent portfolio adjustments because of the cost involved.
CRAs therefore claim that they “rate through the cycle”, providing a long-term perspective, but the question should be asked whether CRAs actually provide useful information in addition to observing the spreads on the relevant bonds in financial markets.
Thirdly, CRAs have been judged to be guilty of pro-cyclical behaviour, thus increasing risk rather than mitigating it and causing greater volatility in markets.
Fourthly, the credit rating industry has been branded as uncompetitive, with the top three CRAs accounting for 95% of the business (see figure below). The way in which credit ratings are being used in fact creates considerable barriers to entry to the credit ratings industry and encourages the perpetuation of the prevailing oligopolistic market structure.
There is therefore a need for greater transparency of credit rating methodologies to strengthen competition and create opportunities for new entrants to differentiate themselves. On the other hand, having fewer CRAs promotes greater uniformity and consistency in ratings, making it easier for investors to compare securities.
Adam Posen of the Peterson Institute for International Economics and a former member of the monetary policy committee of the Bank of England and David Smick went so far as to state that “ratings agencies serve no useful purpose except inherently to mislead investors”, calling for the disenfranchisement of the CRAs.
They ask the interesting question why, if no institution can definitively determine the worth of a stock, it should be true for a fixed-income security.
It is therefore not surprising that the international Financial Stability Board (FSB) has a reduction in reliance on CRAs and increasing oversight of their activities as an objective in order to reduce what it calls “financial stability-threatening herding and cliff effects” from CRA rating changes.
It is the FSB’s purpose to “end mechanistic reliance by market participants (on CRA ratings) and establish stronger internal credit risk assessment practices instead”.
The FSB published a document relating to “Principles for Reducing Reliance on CRA Ratings” in October 2010. This was followed by a more detailed roadmap in November 2012, suggesting specific timelines for steps to be taken in a process that is set to run until 2016.
The last progress report on this at the level of the G20 was lodged in August 2013, but individual countries continue to report on their own progress in this regard (Australia being the most recent one to do so).
The principles are briefly as follows:
- removing CRA ratings from standards, laws and regulations wherever possible;
- encouraging banks, market participants and institutional investors to make their own credit assessments;
- eliminating the use of CRA ratings by central banks and reaching their own credit judgements on financial instruments;
- discouraging the use of CRA ratings in margin agreements; and
- encouraging issuers of securities to disclose comprehensive, timely information (publicly for publicly traded securities) to enable investors to make their own, independent judgements.
In short, although the FSB does not have the complete elimination of CRA ratings as an objective, it certainly aims to relativise CRA ratings by identifying them as mere opinions for which other (better) alternatives are available.
'Up to investor to accept or reject our opinion'
In the few instances where investors have sued rating agencies to compensate them for losses suffered on investments they entered into based on a favourable credit rating that turned out to have been wrong, the ratings agencies themselves have argued as part of their defence that they merely express an opinion and that it is up to the investor to accept or reject that opinion.
Investors who delegate the assessment of risk to rating agencies should therefore remember the caveat emptor rule!
South Africa is also participating in the process initiated by the FSB, although the hardwiring of CRA ratings in regulating the banking sector in particular is mostly through compliance with international frameworks and standards.
The South African Reserve Bank has implemented its own Credit Default Swap model to reduce reliance on CRA ratings and it has moved to prevent inappropriate use of and overreliance on CRAs by financial institutions.
In summary, credit ratings will continue to provide useful although not fully foolproof information, especially to small investors who cannot do their own credit assessments. Perhaps we should just learn not to overreact to the changes in the opinions of CRAs.
References
1. The Joint Forum: Stocktaking on the use of credit ratings. June 2009.
2. Financial Stability Board: Principles for Reducing Reliance on CRA Ratings. 27 October 2010.
3. Financial Stability Board: Road map and workshop for reducing reliance on CRA ratings. 5 November 2012.
4. Financial Stability Report: Credit rating Agencies. Reducing reliance and strengthening oversight. Progress report to the St Petersburg G20 Summit, 29 August 2013.
5. David Smick and Adam Posen: Disenfranchise the Ratings Agencies. The International Economy, Fall 2008.
6. Pragyan Deb, Mark Manning, Gareth Murphy, Adrian Penalver and Aron Toth: Whither the credit ratings industry? Financial Stability Paper No 9. Bank of England, March 2011.
7. Nicolas Véron: Rate Expectations: What can and cannot be done about rating agencies. Brueghel Policy Contribution, October 201 (sic).
- Fin24
*Jac Laubscher is Group Economist of Sanlam. Opinions expressed are his own.
