Agency risks

International institutions have been talking about the need to reform credit rating agencies virtually since the financial crisis began with the implosion of Lehman Brothers. Businesses and governments agree that the ratings decisions by these agencies, with Moody’s, Fitch and Standard & Poor’s controlling that particular market, have led to a destabilizing of sovereign debts as well as the individual ratings of private companies, particularly banks, given that they have acted in a pro-cyclical manner. During periods of prosperity they helped to swell the financial and real estate bubbles, encouraging the proliferation of cheap credit with their optimism. In depressed economic circumstances, the agencies’ actions exacerbate the depreciation of assets and make any recovery more difficult. In short, they swim with the tide.

A working group of the Financial Stability Board (FSB), meeting in New York at the G20’s behest, is this week starting to straighten out the ratings sector based on a report already drawn up by the FSB. Facing up to this problem is an admirable initiative, and even more so because the debate is focusing on the right areas: the basic idea is to review and limit the requisites agencies require from banks and states to guarantee their solvency and reduce the number of interventions the agencies can make in rating such requisites.

This is all very well, but this approach does not get to the basis of the problem. Ratings agencies distort the markets’ perceptions in three fundamental ways. The first is the pro-cyclical nature of their decisions, as has already been mentioned.

The second, and more serious, point is that they operate incompatible lines of business. A recent European Central Bank (ECB) report explains how agencies give better grades to companies and banks with which they also have consulting contracts. A consulting firm cannot be an auditor at the same time, however many Chinese walls and other corporate instruments are put in place in an attempt to disguise a basic conflict of interests. These businesses must be kept separate, in both juridical and corporate terms.

Finally, investors and citizens — in the case of state debt ratings — have the right to know what models and parameters are used in the formulation of an agency’s verdicts. More often than is necessary, these criteria are not revealed to the point that many ratings simply give the impression of being arbitrary. If these methods were known in detail, investors would be able to evaluate their own confidence in the rating decision and act in consequence.

Any reform of the ratings sector must correct these dysfunctions. Agencies are needed because investors cannot formulate their own detailed analysis of each stock and asset. But they cannot be allowed to remain a factor which tends to exacerbate existing crises.