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The Right and Wrong Way to Regulate Credit Rating Agencies

One fallout of the sub-prime crisis has been the anger towards credit rating agencies and calls for regulation. Is regulation the answer?

The Right andWrong Way to RegulateCredit Rating Agencies

One fallout of the sub-prime crisis has been the anger towards credit rating agencies and calls for regulation. Is regulation the answer?

AVINASH D PERSAUD

T
he soothing embrace of central bank liquidity has becalmed credit markets for now, leading to a deep sigh of relief from the big three credit rating agencies: Standard and Poor’s, Moody and Fitch. Just a month ago lawmakers were circling. But relief could be premature, for French finance minister Christine Lagarde recently intimated that the appetite for regulation of the agencies in Europe remains high. Do not forget that the $1.4 billion settlement between Wall Street investment banks and regulators, involving analyst conflicts of interest, was announced two years after the start of the dotcom collapse by Elliot Spitzer, who went on to become governor of New York state.

There are important differences between rating agencies and analysts. Rating agencies do not have the business model of “star analysts” who bag multimillion dollar bonuses. But ratings are as much at the heart of the current “originate, rate and relocate” model of banking, as analysts’ recommendations were to the dotcom bezzle. For seven years banks transferred large volumes of loans or packages of loans, to those who had little knowledge of the issuer, because the instruments carried a rating. Ratings widened the demand for these instruments to the point where banks made an easy living earning fees for originating, repackaging and transferring loans rather than expensively carrying them on their balance sheet. Banks were looking more like traders and some traders were looking more like banks.

Regulators in the group of 10 (G-10) countries took the naïve view that this was a good thing because risks were spread across more institutions.

One fundamental flaw with the originate, rate and relocate model of banking is that credit risks were being transferred, in part, to traders of risk who did not intend to hold on to these instruments for a long time and so had little incentive to invest in learning more about them. In effect, what they were trading was the rating. During periods of low volatility this leads to some efficiencies as traders arbitrage differences between similarly rated instruments. But risk traders are not risk absorbers. In times of rising volatility, constraints to their knowledge and capital means risk traders adhere closely to their risk management models, which invariably tell them to sell what is falling most. They follow the herd and become it [Persaud 2000]. The originate, rate and relocate model improves liquidity in calm times, at the expense of worsening liquidity in times of stress – not a wise trade-off [Lagana et al 2006].

The rating agencies retort that they cannot be blamed for how ratings are used. I have sympathy for this, though it reminds me of what the gun manufacturers say after a mass shooting in the US. What puts the smoking gun in the hand of rating agencies, according to many, is the business model. When markets are under stress, investors question the veracity of ratings. The fact that ratings are paid for by issuers undermines confidence at this critical juncture and contributes to the market freezing up,

Economic and Political Weekly October 20, 2007

with dire consequences, as the shareholders of the UK mortgage lender that has been in trouble, Northern Rock, can tell you.

At first sight the business model appears corrupt. But the reality is that a rating is only valuable if everybody knows it and you cannot get an investor to pay for information he already has. Ratings are a “public good”. Which leaves only two possible paymasters: government or issuers. Government funding would lead to a standard setting (Lagarde is already talking about it) that would stifle insight and innovation. Further, ratings would likely become public guarantees, as investors sought public protection from any losses arising out of their use of publicly approved ratings. This leaves us with issuers.

The rating agencies accept that conflicts of interest exist, but claim they have mitigated them through a disclosure of models and ratings. Having recently tried to conduct a statistical study using ratings, I have not found this transparency as helpful as it sounds. Consciously or not, the agencies have responded to requirements for disclosure in the same way as fund managers have, by overloading the market with differentiated product, making comparisons hard. Some investors genuinely did not know what the rating on their instruments implied.

The wrong direction out of this quagmire would be for regulators to tell agencies how to rate a credit (and then to use these ratings to regulate banks in a dangerous circularity). But regulators could require the industry to standardise what ratings mean. Instead of every rating agency having its own complicated nomenclature there would be one set of definitions. Investors would have no excuse for not knowing what the rating meant. Agencies would be free to innovate in how they came up with these universal ratings and they would then be more clearly measured against an absolute benchmark. Another step would be for regulators to alter the system which incentivises banks and others, who have natural advantages at hedging and holding credit risks, from transferring them to traders who do not [Nugee and Persaud 2006]. This would crimp the originate, rate and relocate model, but it would be an overdue investment in systemic liquidity.

EPW

Email: apersuad@mac.dom

References

Lagana, M, M Peoina, I von Koppen-Mertes and A Persaud (2006): ‘Implications for Liquidity from Innovation and Transparency in the European Corporate Bond Market’, Occassional Paper Series, European Central Bank, No 50.

Nugee, J and A Persaud (2006): ‘Redesigning Regu lation of Pensions and Other Financial Products’, Oxford Review of Economic Policy, Vol 22, No 1.

Persuad, A (2000): ‘Sending the Herd Off the Cliff Edge: The Dangerous Interaction between Modern Risk Management Practices and Investor Behaviour’, Institute of International Finance, Washington.

Economic and Political Weekly October 20, 2007

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