Academics Caution About Increased Rating Agency Competition

In the wake of the mortgage-backed securities debacle and other questionable business practices, regulators in the U.S. and particularly Europe are urging that the “big three” rating agencies face increased competition to drive better quality ratings. However, Bo Becker of Harvard Business School and Todd Milbourn from Washington University, warn that increased competition may not be a solution.

Analyzing Moody’s and Standard & Poor’s reaction to the rapid growth of the then-upstart Fitch in the early 1990s, the authors explain in Financial Times that, “The evidence we uncover appears unequivocally consistent with lower ratings quality as competition increased.” Specifically, as Fitch’s market share grew, the accuracy (measured as the correlation between ratings and bond yields) of a rating fell about one-third and the predictive power of default fell by two thirds.

The authors hypothesize that “…competition most likely weakens reputational incentives for providing quality in the rating industry, and thereby undermines quality. The reputational mechanism appears to work best at modest levels of competition.”

FOX Business Wonders Whether U.S. Deserves Its AAA

FOX Business has joined many European business analysts in wondering whether the U.S. deserves the AAA rating it has maintained since 1917. In light of how other advanced nations’ sovereign debt is being aggressively scrutinized and downgraded, there are those who feel the U.S.’s AAA rating is unwarranted.

FOX believes that the interest cost of the U.S. debt as a percentage of total federal tax revenues is the greatest concern for credit rating agencies. The U.S. needs to keep the interest cost to federal tax revenue ratio stable. This is why there is pressure to raise federal taxes to avoid a credit rating downgrade.

Moody’s says that the United States debt is currently affordable. After peaking at 10% two years ago, the ratio of interest payments to federal revenue has dropped to 8.7% in 2010.

TÜSİAD Scrutinizes Rating Agencies

Ümit Boyner, the chairwoman of the Turkish Industrialists’ and Businessmen’s Association (TÜSİAD) announced at a meeting in Istanbul that the association is conducing research to determine whether large, multinational rating agencies are under inappropriate political influence.

At the Chief Executive Officers Forum sponsored by TÜSİAD Boyner said, “During the crisis, concerns about the decisions of international rating agencies appeared.” The association’s findings will be made public at the November meeting of G-20 countries.

Off the record, Turkish business people are skeptical about the integrity of the international credit rating agencies. Officially TÜSİAD claims that international rating agencies simply have “doubts about Turkey’s economic growth” and that the agencies “need to be convinced” that Turkey’s growth and economic performance is sustainable.

Standard & Poor’s Predicts Unsustainable Debt

In a recently published report by Standard & Poor’s Ratings Services, “Global Aging 2010: An Irreversible Truth,” government debt of countries with advanced economies could reach over 300% of GDP within 40 years.

It is the opinion of Standard & Poor’s that the aging population could dramatically impact the prospects for economic growth while simultaneously facing greater budgetary pressures from increased age-related spending.

To counter this trend, the rising debt, and the negative impact on sovereign debt ratings, European governments have been attempting to make budgetary adjustments and to reform pension and health-care systems. These measures have been facing fierce union protests in France, Greece and most recently Italy.

In their press release, Standard & Poor’s quotes their own credit analyst Marko Mrsnik as saying, “No other force is likely to shape the future of national economic health, public finances, and national policies as the irreversible rate at which the world’s population is growing older. The projected deterioration in public finances between now and 2050 is particularly significant in advanced economies, whereas many emerging market sovereigns outside of Europe will have a slightly more positive trajectory. In these cases population aging is projected to take place against the background of relatively higher economic growth than in advanced sovereigns. However, as the emerging sovereigns develop, with associated widespread changes to the social fabric, government welfare spending may grow faster than GDP as has been the trend in advanced economies during the last half of the 20th century.”

Chinese Look To Develop Investor-Paid Rating Agency

The National Association of Financial Market Institutional Investors (NAFMII) is a Chinese self-regulatory organization set up by China’s central bank in 2007. It is now spending 50 million yuan ($7.5 million) to develop a new rating agency to help protect investors as private companies sell more debt.

Central to the establishment of the new rating agency is an investor-paid business model. China’s bond market regulator said that investors must fund the agency instead of issuers to avoid conflicts of interest.

Bloomberg News quotes Shi Wenchao, secretary-general of the NAFMII, as saying, “The credibility of China’s credit-ratings agencies and their authority is not high…The inadequate set-up of the industry in China has imposed no effective external constraints, and has caused some misbehavior in the market.”

China currently has five credit-rating firms all using an issuer-paid business model.

Efforts Made To Delay Ban on Ratings in Rules

Until a better alternative can be developed, banks and regulators are pushing Congress to rethink the ban on using ratings agencies’ assessments in regulations used to oversee banks.

They say the ban is too much too soon and forces regulators to rely on untested tools when assessing banks’ viability. Specifically, the worry is that banks may avoid holding public and private debt because of the work involved in demonstrating to regulators that those investments are at a low risk.

Barbara Roper, director of investor protection at the Consumer Federation of America and a leading advocate for tough financial reforms, is quoted by Reuters as saying, “This one, I just think in the heat of the moment, they didn’t think it through.”

It may be difficult for regulators to moderate the ban or to convince lawmakers that it needs to be narrowed. The ban was one of the few aspects of the Dodd- Frank reform law that enjoyed bipartisan support.

Regulators have until July 2011 to identify credit rating agencies references in their rules and to develop alternatives.

EU Addresses Foreign Rating Agency Regulation

The European Union (EU) regulators envision two ways to handle ratings from agencies that come from non-member states. The first is to accept ratings of countries that they believe are “equivalent,” such as Japan.

The second way to is to accept ratings from other countries so long as their process is as “stringent” as in the EU and an EU agency has endorsed the assessments.

If the latter is imposed in a strict sense, it could affect both borrowers and lenders from other countries looking to engage Europeans institutions. Banks in particular could have a hard time holding non-EU assets as regulated capital under the new law.

The Financial Times quotes a worried diplomat as saying, “European banks could be shut out of certain capital markets…it’s not a small issue.” The United Kingdom and the Netherlands among other Nordic states are urging a loose interpretation of the regulation whereas France and Italy are pushing for a strict application.

IMF Wants Rating Agencies Regulated

The International Monetary Fund (IMF) has come out in favor of increased regulation of the rating agencies. Their decision was made public in a report and was in reaction to the recent escalation of European sovereign credit risk. The IMF’s opinion was directed specifically at Moody’s, Fitch, and Standard & Poor’s, the only three agencies with a worldwide presence.

“In general, ratings are fairly accurate in foretelling when a sovereign is likely to default, though more attention to sovereign debt composition and contingent liabilities could help improve their rating,” said the IMF.

However the report complained that, “Ratings are embedded in various rules, regulations and triggers, so that downgrades can lead to destabilizing knock-on and spillover effects in financial markets.” A downgrade can lead to a sell-off that drives down the value of the affected country’s bonds, increases the cost of borrowing in the future, and imposes strain on government’s finances.

IMF recommended that policymakers should “wherever possible remove or replace references to ratings in laws and regulations, and in central bank collateral policies.”

New Chinese Semi-Official Rating Agency

Chinese officials have been candid in expressing their opinion that the three major rating agencies, Standard & Poor’s, Moody’s and Fitch all had conflicts of interest that led them to assign top ratings to securities that later turned out to be junk.

To work around these agencies, China is establishing the China Credit Rating Company (CCRC) that will charge investors instead of issuers to assess investment risk.

It is intended that the CCRC be a not-for-profit organization, which will be funded by the National Association of Financial Market Institutional Investors (NAFMII), a trade group within the People’s Bank of China, China’s central bank.

Because the agency will be circumventing what they believe to be a fundamental conflict of interest that has plagued leading Western agencies, the Chinese believe the CCRC will have more credibility.

Liu Shiyu, a vice governor with China’s central bank, stressed the value of independent risk assessments. “The new firm is a tentative effort on this road,” Liu said. “But we also need to be aware that it will be a very difficult task to reform the ratings industry.”

The charging model for this new rating agency is still to be determined.

The Next Best Thing

It’s about time.

I’m glad someone else noticed that the NAIC has a workable solution. It might not be optimal, but it works.

(I would prefer to have the ratings fixed, rather than replaced).

See our posts starting 11/19/09.

[$$] No Ratings? No Problem –  American Banker, March 11, 2011.

« Previous Page — Next Page »