The now infamous downgrade of US sovereign debt in August followed a year in which a handful of European nations had their ratings ignominiously slashed.
Each downgrade – including those of Portugal, Ireland, Greece and Spain – prompted outrage from domestic politicians and commentators alike, feeding a view that, in the eyes of many, credit rating agencies had become public enemy number one. That perception was confirmed in late September, when Italy’s credit rating was downgraded by Standard & Poors. The result has been ever more fervent calls to speed up languishing efforts to curb the role agencies play within the regulatory system on both sides of the Atlantic – and to hold them more accountable for their actions.
The downgrades have reawakened questions about the agencies’ decision-making, timing and methodology.
But much of the noise surrounding recent sovereign downgrades themselves rings hollow, with politicians playing to the gallery and, in the process, betraying glaring double standards; many of the agencies’ fiercest detractors today had previously slammed their slowness to act on other occasions, most notably in downgrading US mortgage-backed securities in the run-up to the US financial crisis in 2007.
US politicians rounded on Standard & Poor’s – the agency which in August cut the nation’s long-term sovereign credit rating from AAA to AA+ – accusing it of factual errors and inappropriate interference in the political process. Meanwhile European politicians have accused the rating agencies of toying with their children’s future and even of having an anti-European bias.
“The rating agencies are being criticized for finally doing their job,” says Geoffrey Wood, professor emeritus of economics at City University London’s Cass Business School, an expert on financial regulation and former special adviser to the Bank of England. “They’ve been criticized since they started to get things right, and eventually people will realize that these politicians are just being stupid.”
Ted Truman, senior fellow at the Peterson Institute for International Economics and a former US assistant Treasury secretary, says: “Part of the problem in Europe is the politicians. On the one hand, they have complained about an Anglo-Saxon conspiracy; on the other hand we have a rule saying that rating agencies can’t rate countries under a programme.
“That strikes me as saying ‘we’re in big trouble, so we’re going to turn out the lights.’ It’s not constructive any way you cut it.”
The agencies themselves have largely shrugged off the more specious attacks. “In any country where we do this, we get this kind of reaction. No one reacts positively to a downgrade, so it’s not novel or new,” Paul Coughlin, executive managing director of Standard & Poor’s Global Corporate & Government Ratings Group, tells Emerging Markets. “It’s been a much more public expression of displeasure. But our job is to call it as we see it and not to think about the reaction.”
MODEL RESERVATIONS
But proponents of meaningful reform hope that public anger over headline-grabbing downgrades can finally be channelled towards changing the system.
Among the long-standing concerns voiced by agency critics is the conflict of interest inherent in the revenue model used by the big three firms – S&P, Moody’s and Fitch. Under the so-called “issuer pays” model, debt issuers pay the agencies for their ratings, which are then made available to investors and the public. Agencies, the charge goes, are thereby fundamentally compromised, while in theory issuers can shop around for the most favourable ratings.
Al Franken, Democratic senator for Minnesota, is among the most outspoken critics of the existing model. He tells Emerging Markets: “[These] conflicts of interest incentivize credit rating agencies to give triple-A ratings to unsafe investments. They were a key factor in our recent economic collapse.”
Franken and Roger Wicker, Republican senator for Mississippi, are trying to combat this by pushing for the establishment of a rating agency board that would assign credit rating agencies to rate each specific structured financial product; issuers would still pay for the rating, but wouldn’t be able to shop around the agencies.
The joint Franken-Wicker amendment was tabled as part of last year’s Dodd-Frank Act on US financial regulatory reform, but with the proviso attached that the Securities & Exchange Commission (SEC) has two years to come up with an acceptable alternative, an proviso that Franken has likened to a “downgrade”.
Others have suggested agencies revert to a model whereby investors, rather than issuers, pay for ratings – the prevailing approach until the early 1970s. “It worked well,” says Wood. “I don’t see why it can’t work that way once again.”
But the so-called subscriber-pays model is not any more immune to conflicts of interest: it simply shifts the emphasis to the investors, who can then shop around for ratings most closely suited to their investment bias, according to Frank Partnoy, professor of law and finance at the University of San Diego and a long-standing advocate of curtailing rating agencies’ systemic importance. Such a model could also limit the number of securities that get rated, especially if investors decide not to pay across the board for the privilege.
A third suggestion is to remove ratings from the private sector altogether by setting up publicly-funded and administered bodies instead. Plans have been mooted, for example, for an independent, publicly-funded European rating agency. But the proposal has been widely condemned on the grounds that an agency funded by sovereign debt issuers themselves is no more trustworthy.
Moreover, public bodies could find themselves struggling to hire and retain the talent needed to stay ahead of complex financial innovation. “Making ratings part of the public sector might make the errors bigger rather than smaller,” says Phil Suttle, chief economist at the Institute of International Finance (IIF), a trade association of the world’s biggest banks.
Rating agencies recognise the potential conflict of interest under the current revenue model. But S&P’s Coughlin says disproportionate emphasis on agencies’ revenue models risks diverting attention away from more fundamental systemic regulatory concerns.
“There is no evidence to show that it was the business model that caused this error of judgment [over US mortgage-backed securities], and there is nothing to lead you to believe that an investor-supported business model would be superior, practical or indeed would somehow lead to all these problems going away. It really wouldn’t,” he says.
“To continue to harp on about this issue of the business model is to miss what happened there. Everyone else across the financial community came to the same conclusion about US mortgage-backed securities as the ratings agencies. The major issue is why all these people with various interests and varying missions came to the same conclusions that turned out to be unreliable. That’s the big issue.”
NO RATINGS IN REGULATIONS
Much more pressing, says Partnoy, is a second strand of reform being pursued in the US: getting rid of the regulatory requirement for financial institutions to use ratings to justify investment decisions and to show their adherence to capital adequacy ratios.
The ratings requirement has become an integral part of global finance both on the regulatory side and within the banking sector; the Basel II accords, for instance, absolved banks of the requirement to set aside capital against any sovereign debt rated above AA-.
For Wood, the regulatory requirement is the main reason why rating agencies have come to play such an excessively important role within the financial system. “When people say that ratings agencies are too powerful, they have of course been made more powerful by governments telling banks that they have to take account of those ratings,” he says. “The rating requirement is wrong-headed and should be removed overnight. Ratings should be there as just another source of information, not as definitive measures of risk.”
Moves to break this link are already afoot in the US. Section 939A of the Dodd-Frank Act orders agencies to review and replace references to credit rating agencies in their regulations with “alternative measures of credit worthiness”.
However, little progress has been made towards the enforcement of that provision. Lawmakers delayed its implementation for two years when the law was passed in June 2010, while SEC and Federal Reserve officials have failed to reach consensus on what form these alternatives might take.
Financial institutions have expressed concerns about the potential uncertainty such a move could cause, raising doubts over whether Section 939A will be implemented.
But the failure to agree on an alternative is alarming, says Partnoy. “The fact that both regulators and many financial institutions have [failed to come up with an alternative system] is deeply troubling on a number of levels, probably the most fundamental of which is regulators saying ‘we’re so awful that we can’t do this on our own, so the only thing we can do is rely on companies that have been demonstrably false over a period of decades,’” he says.
Nevertheless, while regulators and the financial sector have spoken out against doing away with the regulatory requirement to reference ratings, the rating agencies themselves are – publicly at least – backing such moves, even though it would almost certainly erode their influence and profitability.
“We have never lobbied for ratings to be embedded in regulations. That has never been our position going back a decade or more, and we certainly don’t believe that people should be compelled to use ratings,” says S&P’s Coughlin. “The core of our business is servicing the investment community, and I don’t think we’ve ever needed official endorsement to succeed in that community.”
For Partnoy, this is simply a canny exercise in damage limitation. “[Rating agencies] got beaten very severely [post-financial crisis], and they cannot afford to take another beating like that, so I think that they publicly have to support [these efforts], but privately they are betting that the alternative system that regulators come up with will still have ratings as a component.”
Coughlin flatly denies that charge, pointing out that agencies had said “much the same thing” a decade ago. “Unfortunately, even though we were saying it, it wasn’t considered newsworthy, and it wasn’t publicized.”
THE QUEST FOR ALTERNATIVES
Yet if not ratings, then what? Even the contours of an alternate system have yet to be sketched.
Credible alternatives to ratings, says Partnoy, could include: market measures of credit risk such as a 30- or 90-day rolling average of market-based credit spreads or credit default swaps (CDS); or moves towards a subjective fiduciary-based system, requiring individual market participants to make their own judgments.
Moving away from a single risk assessment benchmark could have the benefit of forcing both regulators and investors to do their homework on financial products – especially complex structured products – before they buy them.
“Nobody who invests in complex financial instruments should rely on ratings. At most ratings agencies should be a starting place from which to do their own due diligence,” says Truman. “Investors shouldn’t buy an instrument if they don’t understand how it’s going to get paid off or how its value could change.”
But financial institutions are unlikely to embrace a brave new world of subjective risk analysis, says Partnoy, especially since investors and institutions must be able to justify their decisions to stakeholders.
A more realistic solution could be a more pluralistic risk assessment benchmark that takes into account the views of credit rating agencies together with market measures.
What’s clear is that there is as yet no credible alternative, a fact which means credit rating agencies are likely to continue to play a central role within the financial system. “If a viable alternative to the ratings agencies exists, I’d be very impressed, because I really don’t know what it might be,” says the IIF’s Suttle.
Creating a raft of new agencies would be like trying to reform the software industry by abolishing and creating a new Microsoft; forcing all debt intermediaries to do their own analysis would result in huge costs for those who can afford to do their own research and massive barriers to entry for smaller market participants.
As for relying on market measures, “anyone who thinks that markets are more able to see through the fog of uncertainty needs their head turning.”
REGULATORY CONFUSION
Another problem is the lack of regulatory coordination across geographies and sectors. This risks contradictory and competing regulations that could hinder attempts to enhance risk assessment mechanisms.
So far there has been little sign of coordination of regulatory efforts on rating agencies between US and European policymakers. Although US regulators are aiming to remove ratings from regulation, their European counterparts are instead seeking greater regulatory oversight of the agencies. Meanwhile credit ratings will continue to play a major role in global banking-sector regulations under Basel III, which mandates banks to justify their tier-one assets as part of liquidity requirements with reference to credit ratings.
This lack of coordination is a cause for grave concern, experts say. “Whenever you are talking about something that has systemic risk concerns, you need to have global coordination, and this hasn’t been happening,” says Partnoy. “Ideally the Dodd-Frank treatment of credit rating agencies would have been coordinated with Basel and the European approach, but it wasn’t; it’s been much more territorial, and we’re going to have piecemeal legislation as a result.”
Suttle says such regulatory fragmentation could see financial institutions become less willing to work across borders. “If you feel that there are random and different sets of rules across different jurisdictions, then you may well decide to operate in a place you feel you understand best,” he says.
OUT OF THE FRYING PAN...
As a result, Suttle reckons Dodd-Frank proposals are unworkable and likely to end up being a huge waste of time, effort and money.
“The tabled reforms risk taking us out of the frying pan into the fire,” he says. “What was put into Dodd-Frank is a classic case of saying ‘we aspire to do this, but have no clear way of going about it’. They present all sorts of problems.”
Rating agencies have been made scapegoats for system-wide failures. Says Suttle: “Ratings are indispensible. As much as you might want to blame specific institutions for doing certain things and getting things wrong, rating agencies don’t stand out as getting anything wrong more than anyone else.”
S&P’s Coughlin is baffled by what he sees as undue attention on the agencies at the expense of broader regulatory reforms. “I don’t hear people saying bank regulators were either conflicted on this or incompetent and therefore we should have less bank regulation. In fact, we seem to be going in the opposite direction,” he says.
For long-term campaigners for reforming the rating agencies, the struggle goes on – though the solution may lie in the courts rather than with the politicians. Partnoy has called for legal reforms to ensure that rating agencies can be held accountable for their ratings after the fact, as well as for the introduction of anti-abuse regulations, akin to those governing taxation, that would penalize rating agencies and market participants for “creating and endorsing financial innovations that are designed to exploit loopholes in regulations”.
Rating agencies, though, have vehemently opposed moves that would make them accountable for their ratings, arguing they are entitled under freedom of speech legislation to express their opinions freely and without recourse.
Champions of reform, including Franken, are confident that meaningful regulation can be pushed through, although he acknowledges that what the regulation looks like in the end is less important than the underlying aim to “protect consumers from future economic hardships or collapse”.
But the question is whether attempting to do so by radically reducing the role of credit rating agencies is the most useful way to achieve it. So far, a lack of credible alternatives suggests that it may not be.