Financial regulators are breeding global instability by forcing banks to rely on sovereign credit ratings to determine risk exposures, a former executive managing director of Standard & Poor’s has charged.
“Regulators have created a huge dependency on ratings, and this is a significant structural flaw in the financial system,” Barbara Ridpath, former head of the Standard & Poor’s Europe, Middle East and Africa ratings business, said.
She also dismissed the European plan for a state-backed agency, saying it could not be objective.
Old bank regulations, known as the Basel II standards, link banks’ capital requirements to sovereign credit ratings. The upcoming Basel III standards retain this rule, but also allow for the alternative possibility of banks using their own internal models for assessing credit risk, subject to regulatory oversight.
Ridpath, now head of the International Centre for Financial Regulation, a research group, said Basel III should entirely remove the rule that hardwires sovereign credit ratings as a means to determine banks’ risk exposures. This calculation of capital strength then determines the ability of banks to finance themselves from the market and central bank.
“In many ways, agencies can only fail, because they are only marginally better at analysis than everyone else” – and yet ratings are built into the financial system as a scientific assessment of risk, she said.
S&P’s downgrade of the Greek and Portuguese government debt caused a surge in Greek borrowing costs that left the government unable to finance its deficit in the market a week later. This triggered the historic Greek bailout package worth more than E100 billion.
The downgrade set off a tide of criticism against credit ratings, as they were accused of drastically underestimating southern Europe’s creditworthiness. Because investors and banks rely on ratings for buy and sell signals on sovereign debt, it creates a knock-on effect and “no-one wants to catch a falling knife”, she said.
Ridpath argued that financial regulators have a “self-interest” in relying on sovereign credit ratings as a means of passing on the blame if risk assessments prove faulty.
The IMF’s global financial stability report, released on Wednesday, said an over-reliance on sovereign credit ratings had inadvertently contributed to the crisis. It recommended that ratings agencies attach a probability on a rating rather than just ranking governments’ creditworthiness.
Ridpath said: “This makes me really nervous, as market participants will see ratings as even more quantitative in nature – when they are just opinions”.
The European Commission last week announced plans to create a new state-backed ratings agency. But Ridpath said: “no government agency will be objective”.
The ratings business is a “natural oligarchy” because the barriers to enter are high, including the need to have a strong reputation and history of assessing credit risk before winning clients, she said. This lack of competition heaps on the risk that ratings analysts’ are subject to group-think.