A single-pronged approach is unlikely to solve the problems inherent in the current model for credit rating agencies.

A cynical colleague once remarked that credit rating agencies (CRAs) were like cockroaches; distasteful, but with an unmatched ability to survive. This flippant remark had the weight of experience behind it. But to a young trader near ground zero of the nuclear blast that was the US housing and structured credit market meltdown, CRA survival looked unlikely. Their fingerprints were all over the structured credit disaster and it looked as if it was only a matter of time before the regulators hauled them off to join the Arthur Andersons of the world.

Cynicism and experience triumphed once again in financial markets. CRAs have not only survived but they are now enshrined as Nationally Recognised Statistical Rating Organisations (NRSROs) in the US. Their share price may have halved from the peak but their influence has probably doubled. Sovereign governments across the Western world shake at the mention of the ‘D’ word from any of the three CRAs (for all intents and purposes, only the three matter). Their banking system is kept afloat by central banks that use credit ratings to disburse cash against assets pledged by commercial banks.

The Twin Problems

The rating agencies owe their survival to the inherent nature of debt markets rather than to some unusual talent that they possess. Disintermediation of the debt market means that several lenders advance sums to a single borrower with each accounting for a small proportion of the whole. It also drastically reduces barriers to entry for potential lenders, leading to non-specialist and smaller investors buying debt instruments. In addition, slavish devotion to the theory of diversification has led each lender to invest only a small proportion of his/her portfolio in the borrower’s debt. Thus for most individual investors, the costs of due diligence and continual monitoring of the borrower’s credit strength are too high compared to the expected return. This opens the gap for an expert independent assessor of credit quality who can provide due diligence and monitoring cheaply by spreading the cost to all beneficiaries. In theory, this is what CRAs are supposed to do. However, practice has deviated from theory with credit evaluation costs being borne by the borrower rather than lenders. The conflict of interest is obvious since he who pays the piper calls the tune.

If conflict of interest is the original sin then it has been compounded by investor indolence. The combination of a liquid tradeable market in debt and a short-term investment horizon dissuade time-consuming analysis by investors. Moreover, ratings are a shield behind which highly intelligent fund managers and bankers can lose money conventionally. Cutting through the verbiage, the gist of most post-crisis explanations was: ‘It’s not my fault, subprime collateralized debt obligations (CDOs) were rated AAA. And our closest competitors have lost even more money.’ Unfortunately this shield has been institutionalised and officially recognised through Basel norms and other regulatory directives that use ratings to determine capital and liquidity requirements.

Dodd-Frank and Basel III

Any regulation that seeks to improve the entire credit rating and application process needs to address these twin problems of conflict of interest and investor indolence. In the US the Dodd-Frank Act, despite its drawbacks, goes far in eliminating the egregious excesses of CRAs that fed the credit bubble. Although unable to eliminate the revenue model in which the borrower pays for the ratings, the Act increases the potential liability for wrongdoing. By eliminating Rule 436(g) under Section 11 of the Securities Act, the Act effectively brands them as experts and opens them to lawsuits. CRAs are liable if a credit rating included in a debt security’s offering and registration statement is found to be inaccurate. It speaks volumes that after the passage of the Act, the four biggest CRAs (Moody’s, Standard and Poor’s, Fitch, DBRS) indicated an unwillingness to permit the inclusion of their ratings in offering documents. Additionally, the Act makes the enforcement and penalty provisions of the Exchange Act applicable to rating agencies. It also reduces the burden of proof that the plaintiff has to bear in such cases.

Simultaneously, Dodd-Frank attempts to take away the ratings crutch that investors relied upon. It replaces references to credit ratings in federal laws and regulatory directives, which impact investment decisions, by broader standards of creditworthiness. This is not a cure for investor indolence but is in the direction of a correct policy response. Reduction and elimination of official sanction to credit ratings is the most that policy can hope to achieve in a free market. Unfortunately, branding CRAs as Nationally Recognised Statistical Rating Organisations is a retrograde step. Coupled with vagueness on the standards of creditworthiness deemed appropriate, investor reliance on ratings will continue.

The reliance on credit ratings and the apparent irreplaceability of CRAs is even more pronounced beyond the USA. Basel III norms, which are sought to be applied globally, make use of credit ratings to evaluate liquidity and counterparty credit risk. Moreover, the pressure to game ratings or indulge in ratings arbitrage by banks will still be prevalent since Basel III calculates their Risk Weighted Assets (RWAs) and capital requirements based on ratings. The continuation of the central role that CRAs play is due to a lack of alternatives. Basel III encourages banks to use internal rating models but these are opaque and cannot be easily evaluated on their effectiveness and conservatism. Also less sophisticated banks do not have the expertise or money to develop these models.

Is there a solution?

Therefore on an international level, little has changed with regard to credit ratings in the aftermath of the credit crisis. Additionally there is no consistency in the application, evaluation and regulation of credit ratings across nations. In each country, international CRAs are usually supplemented by domestic CRAs and both operate under different legal and regulatory regimes. The regulatory disconnect between Dodd-Frank and Basel III is just one instance. Furthermore, as Basel III is not an enforceable treaty, national bank regulators have considerable leeway over implementation. All of this poses a problem for regulators and policymakers looking to control transnational financial institutions from repeating their mistakes.

Counter intuitively, the solution lies not in the area of improving credit rating methodology and application but in enforcing market discipline. It is true that consistency in rating methodology, application, and regulation across national boundaries is desirable and would go a long way. But it is almost impossible to achieve not only because of political compulsions but also because of differences in debt markets across nations. Therefore the solution is two pronged. First, there needs to be an international effort to ensure that national regulators address the twin problems of conflict of interest and investor indolence. In this regard, Basel III is a disappointment and Dodd-Frank should be the starting template. Exposing the CRAs to market forces and regulating them as any other professional market participant, would temper their behaviour. And it can be achieved without draconian regulatory interference. Second, the basic precept of capitalism; failure, should be allowed. Indolent and idiotic financial institutions and investors should face the consequences of their actions. A bankruptcy regime that minimises fallout to the real economy is clearly not beyond the ability and understanding of policymakers to devise. There is no need to inject moral hazard into an already diseased financial system.

The views expressed in this article are the author's own and do not necessarily reflect Fair Observer’s editorial policy.