Has the reputation of the major credit ratings agencies (CRAs) – badly tarnished in the 2008-09 financial crisis because of ill-judged ratings, now been restored? If reputation means credibility and confidence in their output, such a claim appears optimistic – or at the very least premature.
While the global ratings agencies, including Moody’s and Standard & Poor’s (S&P), have seen an impressive bounce-back of their businesses since the unprecedented market disruption in 2008, the viability of their business models, as demonstrated by more recent events, remains controversial.
Such a situation, where ratings agencies – endowed with power to move markets significantly – can make major errors and still pursue egregious practices, would hardly be tolerated in many other instances, given its potential to aggravate financial market instability. Investors and bankers, it seems, continue to place excessive reliance on external credit ratings in the marketing and trading of debt obligations, despite the experience of the past seven years – and of the numerous caveats expressed even by the ratings agencies themselves about the use of their opinions.
The credibility of ratings agencies remains eroded for many sophisticated investors, as evidenced by the CFA* Institute’s June 2014 survey, among other polls. Bankers and the companies that they represent could be among only a few willing to speak publicly in favour of the ratings agencies, as a quick canvass of published opinion for this article revealed little positive sentiment.
The scandals of the rated sub-prime structured vehicles would have seemed enough to put the ratings agencies out of business. These are well documented, but to offer just one example by February 2008 Moody’s Investors Service had downgraded, by 54% and 39% respectively, the sub-prime tranches it had rated in 2006 and 2007. S&P by March 2008 had downgraded 44% of the sub-prime tranches it had rated between the first quarter of 2005 and third quarter of 2007. Based on received rating agency and credit wisdom, this is entirely beyond expectations and begs for explanations beyond just extreme events.
Furthermore, the more recent sovereign ratings experience in Europe is not suggestive of improved practices: EU officials argue that the major agencies exacerbated the European sovereign debt crisis by mis-reading the potential for wider support.
As further proof of reputational damage, the big agencies have been blighted by onerous legal complaints: S&P’s US$1.37bn settlement of crisis-era suits with various US states, finalised in February 2015, is a prominent example. The agencies moreover have been accused of favouritism. A study published in November 2013, ‘Did going public impair Moody’s credit ratings?’ by Simia Kedia of Rutgers Business School and others, adduced evidence that the agency was more lenient with companies in which its major shareholders were invested.
The inherent conflicts of interest in the global ratings agencies’ business models have long been recognised, leading to discussion of US reforms dating back to 2002 and earlier. Is it too late to re-establish the subscriber paid model, as entities such as Egan-Jones (EJR) have pursued? If ratings represent value to investors, should they not be willing to pay for them?
There is a behavioural aspect to this as well. Emilios Avgouleas, professor of banking law and finance at Edinburgh University, is one of a number of commentators who has (in the series ‘Lessons from the Financial Crisis’ published in 2010 by Robert W. Kolb) raised the issue of cognitive bias on the part of ratings agencies and investors in propagating the over-reliance on the agencies’ judgements. These are symptomatic of availability and representativeness heuristics, which also plague many aspects of decision making both within and outside of finance. The substitution of in- house or independent models of credit assessment may not entirely eliminate subjectivity or cognitive bias in reaching such assessments, but can further reduce it.
The agencies’ mis-steps have led to many calls for de-emphasising external ratings judgements. The Bank for International Settlements (BIS), in developing the Basel III capital adequacy framework, is recommending far lower reliance on external credit ratings, advocating no reference in either the standardised or advanced approach to risk weightings – unlike the process under Basel II, when the agencies were still riding high.
While national regulators are not always infallible, recent pronouncements made by some influential ones suggest a rising trend towards weaning investors and bankers from the use of external ratings: the US in 2010 and earlier; Singapore in 2013; Australia in 2014; and Europe again in 2015 and ongoing.
Over-reliance still evident
Despite all this controversy, Moody’s has more than doubled its operating income since 2009 and seen its share price rise from a low of US$20 in that year to around US$100 today. S&P, an operating unit of McGraw-Hill, achieved operating income exceeding US$1bn in 2014; somewhat behind Moody’s US$1.5bn. Both agencies, in addition to Fitch, are benefiting from additional services provided in terms of more quantitative credit assessment models, such as Moody’s KMV.
The dissemination of such models is helped by what seems to be still strong brand recognition, even though many institutions could be capable of building reliable in-house models of their own, better tailored to their own individual businesses. This business diversification of the agencies could be perpetuating the problem of over-reliance, in that many institutions thus continue the practice of mechanistic dependence on credit rating models provided by the ratings agencies in a new guise.
However, the news may not be all bad. By making these quantitative models, based on academic theory, available to a wider practitioner audience, the agencies could be helping to bridge the gap between the theoretical foundations and the practical implementation of techniques to better identify and refine solutions to the credit risk problem. They also have valuable historical data bases of credit history. This is something that academia or banks alone (or even together) may not be able to achieve readily, as the time lag between discovery and application tends to be long and business and academia still must find ways to work together more effectively.
Nonetheless, even these new tools must not be seen as a panacea, but should be viewed as an adjunct to other means of assessment involving individual judgement.
It is hard to change habits developed over a 100-year period, even after wrenching events such as the global financial crisis. Yet a fundamental review of the use of external credit ratings, as many have already recognised, is still needed in order to help break the cycle of over optimism followed by excessive pessimism to which the ratings agencies inevitably contribute. Institutions must be further encouraged to develop their own models in house, guided by best practice not from the vested interests of the ratings agencies but by more independent observers, academics, regulators and practitioners.
Has the reputation of the global ratings agencies been restored to its former pristine state (if ever it was such)? Not exactly based on the evidence to date, which continues to trend negatively towards the agencies’ business models and practices.
Eventually market participants will have to force a change to more independent and reliable methods of credit assessment, as it becomes increasingly clear that regulation or government intervention is unlikely to accomplish this effectively.
*Chartered Financial Analyst