Rate Expectations- What Can and Cannot Be Done About Rating Agencies (English)

7/29/2019 Rate Expectations- What Can and Cannot Be Done About Rating Agencies (English)

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ISSUE 2011/14OCTOBER 2011 RATE EXPECTATIONS:

WHAT CAN AND CANNOT

BE DONE ABOUT RATINGAGENCIESNICOLAS VRON

Highlights

Credit rating agencies have been under the spotlight since the beginning of thecurrent financial crisis. They failed in their assessment of US residential mort-gage-based securities in the mid-2000s. Nevertheless, investors generally consi-der credit ratings useful to help form their views on credit risks.

The global market for credit ratings is very concentrated, ostensibly as a conse-quence of high natural barriers to entry. All three leading rating agencies haveheadquarter functions in the US, but there is no compelling evidence that this has

created an analytical bias.

Tighter regulation of rating agencies can be envisaged but is unlikely to have amaterial positive effect on ratings quality. Better standardised public disclosureson risk factors by issuers are the most promising avenue for future improvementsin credit risk assessments.

This Policy Contribution is based on a briefing note for the Polish Presidency of theCouncil of the European Union. Nicolas Vron ([email protected]) is a SeniorFellow at Bruegel, and a Visiting Fellow at the Peterson Institute for International

Economics.

Telephone+32 2 227 [email protected]

www.bruegel.org

BRUEGELPOLICYCONTRIBUTION


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RATE EXPECTATIONS: WHAT CAN AND

CANNOT BE DONE ABOUT RATING AGENCIESNICOLAS VRON, OCTOBER 2011

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1. Marc Ladreit deLacharrire, a French

businessman, controls 79percent of Fimalacs shares

and 87 percent of votingrights. The Hearst

Corporation, a mediaconglomerate, is owned bya trust administered by 13

Trustees, including fiverepresentatives of the

Hearst family.

2. Of this list, all exceptDagong are registered with

the US Securities andExchange Commission

(SEC), which designatesthem as Nationally

Recognized StatisticalRating Organizations

(NRSROs). A 2009application for registration

by Dagong was notaccepted by the SEC (SEC,2011a, p4). At the time of

writing, most prominentCRAs are not yet registered

with the EuropeanSecurities and Markets

Authority (ESMA).

3. Source: annual report of

Fimalac (2009-10).

4. Includes all the otherCRAs listed in the main text

except for Dagong.

However, their volumes of activity are dwarfed bythose of the big three, as Table 1 suggests.

CRAs rate different types of issuers or issuances.For example, Fitch reports that in 2009-10 it rated

around 6,000 financial institutions, 2,000 non-financial corporates, 100 sovereign states and200 territorial communities, 300 infrastructurebond issuances, 46,000 US municipal bondissuances, and 8,500 structured productissuances3. A simplistic but common way of seg-menting the market is between sovereign ratings,corporate ratings, and structured credit ratings.

THE PROBLEMS WITH CRAS

This section summarises the most often men-tioned problems linked to CRA activity, andassesses their materiality.

1 CRAs are unreliable

Measuring the accuracy of credit ratings is intrin-sically difficult, even with hindsight, because theycorrespond to probabilities. A poorly-rated issuermay avoid a default even though the probability ofdefault was high; conversely, a highly-rated issuermay default even though the probability of it was

low. Thus, strictly speaking ratings quality canonly be measured on average over many rating

CREDIT RATING AGENCIES (CRAs) are prominentparticipants in the assessment of credit risk byfinancial markets. They determine and publishcredit ratings, which represent the CRAs opinionson issuers relative probability of default. The

market for credit ratings is currently dominated inmost western countries by three players:

Standard & Poors (S&P) is a division of theMcGraw-Hill Companies, a US-based mediagroup whose ownership is dispersed (thelargest shareholder is Capital Group, with 12percent of shares);

Moodys Corporation is an autonomous US-based listed company with dispersed owner-ship (the largest shareholder is BerkshireHathaway, with 12.5 percent of shares);

Fitch Ratings, a division of the Fitch Groupwhich is jointly owned by Fimalac, a Paris-based listed investment vehicle (60 percent ofshares), and the US-based Hearst Corporation(40 percent of shares)1.

Other notable rating agencies include AM Best(US-based, specialised in the insurance industry);Egan Jones (US); Kroll Bond Rating Agency (US);the ratings unit of Morningstar (US); DominionBond Rating Service (Canada); Japan Credit

Rating Agency (Japan); Rating & InvestmentInformation (Japan); and Dagong Global (China)2.

WHAT CAN AND CANNOT BE DONE ABOUT RATING AGENCIES? Nicolas Vron

Table 1: Dominance of the big three CRAs

S&P Moody's Fitch Others4

Revenue (US$m) 1,696 2,032 657 n.a.

Share of big three total 39% 46% 15%

Operating earnings (US$m) 762 773 200 35

Share of total 43% 44% 11% 2%

Outstanding credit ratings 1,190,500 1,039,187 505,024 81,888


Credit analysts and supervisors 1,345 1,204 1,049 392


Source: annual reports and SEC (2011a and 2011b), authors calculations.


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opinions, based on the law of large numbers, andnot on individual ratings. Moreover, according to

the CRAs, their ratings measure relative probabil-ities of default, not absolute ones. An AA rating sig-nals a lower probability of default than a BBB, butCRAs do not provide a numerical estimate of therespective probabilities (even though they do pub-lish historical data on the frequency of defaultassociated with different past ratings).

From this standpoint there was a clear failure ofCRAs when it came to US mortgage-basedstructured products in the mid-2000s. Manymortgage-based securities were highly rated buthad to be downgraded in large numbers followingthe housing market downturn in 2006-07,especially in the subprime segment. Subsequentenquiries, in particular SEC (2008) and FCIC(2011), have convincingly linked the CRAs failureto a quest for market share in a rapidly growingand highly profitable market segment. Undercommercial pressure, CRAs failed to devotesufficient time and resources to the analysis ofindividual transactions, and also neglected toback single transaction assessments with top-

down macroeconomic analysis that could havealerted them to the possibility of a US nationwideproperty market downturn.

While the CRAs fully merit blame for this failure, itshould be noted that the provision of credit ratingsfor residential mortgage-based securities in the2000s was a relatively recent activity comparedto corporate and sovereign ratings, and that thesubprime segment was new within the larger USmortgage market5. In other segments, including

corporate and sovereign ratings, CRAs could relyon much longer and deeper experience of risk fac-tors and past failure patterns. In these more tra-ditional segments, statistical tables published bythe CRAs and others (eg IMF, 2010, Figure 3.7)suggest a generally strong correlation betweenpast ratings and relative average probabilities ofdefault as observed ex post over large numbers.

That said, there have been several past cases in

5. It should also be notedthat no comparable failurehas been observed in otherasset-backed securitiesmarkets in the US, or inEurope or Asia, whosestructured securitiesmarkets are smaller and

more recent than those inthe US.

6. BIS Quarterly Review,December 2010, page 11.

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All three main CRAs have a decent though far from spotless record in sovereign and corporate

ratings, but their hardly excusable failure over the rating of US residential mortgage-based

securities in the mid-2000s has lastingly damaged their brands and reputations.

which rating agencies clearly failed to spot deteri-orations of sovereign or corporate creditworthi-

ness in due time: this was particularly true ofLehman, AIG or Washington Mutual, which keptinvestment-grade credit ratings until 15 Septem-ber 2008. CRAs were similarly criticised for theirfailure to anticipate the Asian crisis of 1997-98 orthe Enron bankruptcy in late 2001.

It appears fair to conclude that all three main CRAshave a decent though far from spotless record insovereign and corporate ratings, but that theirhardly excusable failure over the rating of US res-idential mortgage-based securities in the mid-2000s has lastingly damaged their brands andreputations.

2 CRA downgrades can trigger sudden shifts inrisk perceptions

Since the beginning of the crisis, CRAs have fre-quently been accused of timing their downgradesbadly and of precipitating sudden negative shiftsin investor consensus. However, it is infrequentthat rating downgrades surprise markets gen-

erally they follow degradations of market senti-ment rather than precede it. When CRAs doanticipate, they are often not given much atten-tion by investors, such as when S&P starteddowngrading Greece in 2004.

Specifically, the evolution of euro-area sovereignyields since 2008 suggests that the biggest andmost sudden shifts in investor sentiment havebeen triggered by new information from the policysphere such as, among others, the announce-

ment by Greece of worse deficits than previouslydisclosed, the French-German Deauville declara-tion of 18 October 2010, or the euro-area Presi-dents suggestion of a re-profiling on 16 May2011. These policy signals have had demonstra-ble impacts on risk perceptions, as the Bank forInternational Settlements noted in the case of theDeauville declaration6. By comparison, CRA down-grades of euro-area countries so far have had lim-ited market impact, if any.

Nicolas Vron WHAT CAN AND CANNOT BE DONE ABOUT RATING AGENCIES?


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7. See note 2.

8. The assessment of theseEU regulations is kept

outside the scope of thisPolicy Contribution.

The sovereign downgrade of the US by S&P on 5August 2011 was a special case, to the extent that

the US sovereign debt market has a specificanchoring role for the global financial system andthere had never been a downgrade of US sovereigndebt in living memory. Ironically, it coincided witha sharp increase in risk aversion which resulted ina short-term decrease of yields on US debt. Thedowngrade may have contributed to market jittersabout Frances creditworthiness and Frenchbanks prospects in the days that followed. How-ever, at the time of writing there does not appearto be an analytical consensus on its role in trig-gering these market developments compared toother simultaneous factors.

The upshot is that instances in which CRA down-grades materially affect general market sentimentseem to be possible but very rare, and that nonehas been compellingly observed recently in thecontext of the euro-area crisis.

3 Rating downgrades can trigger pro-cyclicaleffects due to automatic contractual orregulatory mechanisms

References to credit ratings are embedded in anumber of contractual and regulatory provisionsthroughout the financial system. Thus, eventhough CRAs argue that their ratings are mereopinions intended for the judgment of market par-ticipants, they can have a mechanical, pro-cycli-cal effect if such provisions result in, for example,forced selling of a security as a consequence ofits downgrade. The collateral policy of the Euro-pean Central Bank (ECB) is one example.

However, the actual extent of such mechanicalpro-cyclical effects is limited by several factors.Most investment mandates now have significantbuilt-in flexibility to reduce dependency on indi-vidual rating changes. The ECB has displayed con-siderable flexibility in adapting its collateral policyto new developments, including rating down-grades, throughout the crisis. Strikingly, asobserved above, no large pro-cyclical effect on USdebt markets has been observed following the

downgrade of the US by S&P in August 2011.

While credit ratings are affected by economiccycles, they tend to be much more stable than

market-based indicators of creditworthiness(Moodys, 2009). Thus, replacing credit ratings

with market-based measures would reinforce pro-cyclicality.

In short, mechanical pro-cyclical effects of ratingdowngrades are a legitimate concern, even thoughCRAs are not to blame for them. However, theseeffects seem to be already mitigated to a signifi-cant extent.

4 CRAs escape local regulations

CRAs started life outside of the scope of public reg-ulation, often in connection with media and/oradvisory businesses. The US introduced theNRSRO7 process of administrative recognition ofCRAs in 1975, and a more hands-on registrationregime was introduced by the US Credit RatingReform Act of 2006. In the European Union, theregulatory framework was not intrusive until thecrisis, but has evolved rapidly with the adoptionof successive regulations in September 2009(known as CRA 1) and May 2011 (CRA 2)8; a thirdregulation is at an early stage of development.

Other jurisdictions, including Japan, Australia andHong Kong, have also adopted a new CRA regula-tory framework since the crisis.

As with other financial information intermediaries,territoriality is a difficult issue in the context ofsuch regulations. In principle, creditworthinessanalysis of any issuer can be done from any loca-tion. Moreover, the global consistency of credit rat-ings is viewed by most market participants as asignificant benefit. The combination of these two

factors potentially reduces the scope and effec-tiveness of territorial regulation.

Within the EU, this issue has been addressed withthe devolution of most regulatory and supervisorytasks regarding CRAs to the recently created Euro-pean Securities and Markets Authority (ESMA),which in principle guarantees regulatory consis-tency across all EU member states. However, therisk remains of inconsistency or interference withregulatory regimes in non-EU jurisdictions.

5 The market for credit ratings is oligopolistic

The big three CRAs account for most of the market



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9. Sources: annual reportsof McGraw-Hill (2010),Moodys (2010), andFimalac (2009/10),authors calculations.

10. Source: annual reportsof Moodys (2010) andFimalac (2009/10).Equivalent figures were notfound for S&P.

for credit ratings in all western countries, with adominant market share in the hands of S&P andMoodys alone. The existence of high barriers toentry is corroborated both by the incumbentshigh profit margins and by the absence of majorsuccessful new entrants for almost a century.Specifically, the operating profitability over thelast reported fiscal year was 45 percent for S&P,38 percent for Moodys and 30 percent for FitchRatings, measured as ratio of operating income tototal revenue9. S&P, Moodys and Fitch trace theirorigins back to 1860, 1909 and 1913respectively.

The high degree of market concentration need notbe a problemper se. Some markets are highly con-centrated yet highly competitive: an oft-cited caseis the market for colas, with the global dominanceof Coca-Cola and Pepsico. Market concentration iscommon in other financial information segments,

including international financial dailies (FinancialTimes and Wall Street Journal) and financialmarket data providers (Thomson Reuters andBloomberg). Market participants may not want tohandle many different rating scales or method-ologies, in which case a substantially less con-centrated market structure might not besustainable. As noted in a World Bank policy briefon CRAs, there may be a benefit in having a lim-ited number of global credit rating agencies(Katz, Salinas & Stephanou, 2009).

Nevertheless, concerns about market structureappear warranted. They relate less to predatorypricing than to the possibility of a negative impactof market concentration on the quality of ratings.Without competitive pressure, CRAs could becomecomplacent, and neglect analytical rigour and thedefense of their reputation for integrity. The fail-ures of CRAs in rating US mortgage-based securi-ties in the 2000s, as previously mentioned, tendto support this view, even though it is difficult to

determine whether such failures would have beenavoided had the market been less concentrated.

Perhaps less obviously, the CRA incumbents havenot caught up well with changes in financial tech-nology. Their linear rating scales focusing ondefault probability are well suited to a world whereprobability distributions are normal (Gaussian),but become insufficient as risk-transfer tech-niques, such as the use of derivatives, enable thecreation of skewed distributions. A more compet-itive market landscape could arguably be moreeffective at fostering innovative approaches thatwould successfully meet such new challenges.

6 Leading CRAs are non-European

The three leading CRAs retain most headquarterfunctions in New York, even though one of them(Fitch) is majority-owned by a Paris-based finan-cial group. This also reflects the dominance of theUS in the CRAs business: the US accounts for 54percent of Moodys total revenue, and 52 percent

of its global staff is located there; for Fitch Ratings,the corresponding ratios are 42 percent and 35percent respectively10.

This would be a problem if it resulted in a ratingbias benefitting the US or US national interests.The existence of such a bias is questionable. First,CRA teams tend to be highly internationalised. Forexample, S&Ps head until September 2011,Deven Sharma, was born in India, and the numbertwo executive at Moodys, Michel Madelain, is

French. Second, there has been no compelling evi-dence so far that the CRAs corporate culture andmanagement practices result in the promotion ofUS interests to the detriment of ratings quality.

Most recently, the downgrade of the US sovereigncredit rating by S&P, which was aggressively crit-icised by the US government (on 7 August, Treas-ury Secretary Timothy Geithner said S&P hadshown really terrible judgment and theyve han-dled themselves very poorly), has added cre-

dence to the view that CRA judgments are notmaterially affected by territorial bias.

Market structure concerns, in particular the possible negative impact of market concentration

on the quality of ratings, appear warranted. Without competitive pressure, CRAs could become

complacent, and neglect analytical rigour and the defense of their reputation for integrity.



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11. In June 2011, the con-sulting firm Roland Berger

announced it was in prelim-inary talks with Frankfurt-

based partners and thestate of Hesse about estab-

lishing a new ratingsagency in Frankfurt.

12. MarketWatch, Treasury:Government shouldnt be

involved in credit ratings, 5August 2009

POSSIBLE SOLUTIONS

This section reviews and briefly evaluates possi-ble policy initiatives, most of them referred to inrecent public debates.

1 Forbid ratings

Suppressing ratings activity, either on a perma-nent or a temporary basis (eg in turbulent marketconditions, or for countries receiving support fromthe International Monetary Fund or othersources), would represent a significant constrainton the freedom of speech and opinion that cannotbe envisaged lightly. Given what is known of theimpact of credit ratings, there does not appear tobe a public-interest motive that would justify sucha radical measure.

2 New CRAs

As outlined in the previous section, more compe-tition in the ratings market is desirable. On thisbasis, there have been calls for the EU to take theinitiative and publicly sponsor the creation of a

European CRA that would compete with the estab-lished big three. In a recent resolution, the Euro-pean Parliament asked the European Commissionto study the creation of a new European CreditRating Foundation (European Parliament, 2011).

However, it is not evident that the current condi-tions that frame this market, including the regu-latory framework, would allow a lower degree ofconcentration to be reached and sustained on anongoing basis. Attempts by new ventures to enter

the market can be welcomed, but their eventualsuccess cannot be taken for granted11.

A new publicly-sponsored CRA may find it difficultto establish credibility among financial marketparticipants, especially in the sovereign ratingssegment as there would inevitably be a suspicionthat its ratings may be tainted by political consid-erations. It appears reasonable to anticipate that,in order to be a credible alternative to the incum-bents, any new entrant will need to be able to pres-

ent itself as essentially independent from specificpolitical interests, and to convince market partic-ipants that its nationality (however defined) isirrelevant to its ratings decisions.

3 Public standardisation of ratings methodologies

The methodologies and criteria used by CRAs toprepare ratings have a significant impact on rat-ings outcomes, and are inevitably open to debate.For example, S&P has been criticised for havingincluded an analysis of political dynamics in itsrecent downgrade of US creditworthiness. How-ever, the temptation to publicly regulate ratingsmethodologies should be resisted, as it would col-lide with the justification of ratings as independ-ent opinions. In the absence of a global level ofpublic standardisation, such an approach wouldalso threaten the international comparability ofratings.

Thus, the EU and US have been right to committhemselves to refraining from the direct regulationof CRA methodologies so far. A US Treasury officialdeclared in the Dodd-Frank legislative debate thatthe government should not be in the business ofregulating or evaluating the [CRAs] methodolo-gies themselves12. The EUs second regulation onrating agencies (11 May 2011) specifies: In car-rying out their duties under this Regulation, ESMA,

the [European] Commission or any public author-ities of a Member State shall not interfere with thecontent of credit ratings or methodologies (Article23).

4 Changes in the CRAs business model

During their first decades of activities, CRAsmostly relied on investors as their maincustomers, but shifted to their current issuer-pays business model during the 1970s as their

activity expanded significantly. This raises thepossibility of a conflict of interest, because anissuer might leverage the commercial relationshipto obtain a higher rating. A different businessmodel could be imposed as a condition for publicregistration.

Whether this measure would be beneficial,however, is questionable. The most likely outcomewould be a significant decrease in the overallresources of regulated CRAs, as investors have

until now seemed unwilling to pay significantamounts for credit ratings. One US-based CRA,Egan-Jones, is financed by investors but its sizeremains limited: it has five credit analysts and a



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13. Source: Egan-Jones Rat-ings Co.s application forregistration as a NRSRO, 28March 2011, available athttp://www.egan-

jones.com/_/docs/NRSRO/Form_NRSRO_March_2011.pdf

14. S&P has been the sub-ject of a probe by the Euro-pean CommissionsDirectorate-General for Com-petition over fees it chargedfor the distribution of Inter-national Securities Identifi-cation Numbers, which itagreed to cut in May 2011.However, this relates toS&Ps non-rating activities.

15. The US Dodd-Frank Actof 2010 makes CRAs liablefor a knowing or recklessfailure to conduct a reason-able investigation of thefacts or to obtain analysisfrom an independentsource.

16. See for example Euro-pean Commission (2011),end of page 4.

17. See for example Sharma(2011).

18. On the private-sectorside see for exampleEFAMA, ESF and IMA(2008).

total staff of 22, or 200 times fewer thanMoodys13. Moreover, an investor-pays modelwould by no means eliminate conflicts of interest,as (for example) investors who hold a securitymay desire it to be highly rated. Finally, it is to benoted that while conflicts of interest have been asignificant issue in structured ratings, and to anarguably lesser extent in corporate ratings, theyare essentially absent from the sovereign ratingsmarket from which major CRAs derive a very smallfraction of their revenue.

5 Tighter regulation and supervision

The two successive EU regulations adopted in2009 and 2011 resulted in significant regulatoryand supervisory powers for ESMA. Unfortunately,there is no reason to believe such regulation will beenough to eliminate imperfections in the credit rat-ings market. Obviously, regulation of CRAs by the

SEC (in place since 1975 and reinforced by theCredit Rating Reform Act of 2006) did not preventthe subprime debacle. Europes regulatory screwson CRAs are already quite tight, and full imple-mentation of the existing regulations would be war-ranted before envisaging their further tightening.

Moreover, both theory and experience suggestthat regulation generally reinforces barriers toentry in concentrated markets, and there are noreasons to believe the market for credit ratings is

an exception. Thus, tighter regulation and/orsupervision are unlikely to address the problem ofmarket concentration. If anything, they couldmake it more intractable. Moreover, CRA regulatoryregimes in the EU and elsewhere are highly pre-scriptive as to how CRAs should organise them-selves and conduct their business, which coulddiscourage innovation and the pursuit of neworganisational or operational practices that mayeventually lead to better ratings.

6 Assertive application of competition policy

No past competition enquiries targeted at themarket for credit ratings have been identified in

the research for this Policy Contribution14. Norhave reports of anti-competitive practices beenfound. However, a sector enquiry could be envis-aged to address concerns about the possible exis-tence of such practices by incumbent CRAs.

7 A liability regime for ratings mistakes

CRAs maintain that their ratings are independentjudgments and are protected by the freedom ofopinion. Existing regimes make CRAs legally liablefor failure to comply with regulatory requirementsor with minimum standards of due process15. Inview of their market impact, however, there havebeen calls to make them liable for misjudgmentsor inappropriate intent16. France has adopted leg-islation that goes in that direction.

Such an idea may entail difficulties in terms offreedom of speech and opinion. Moreover, its

impact in terms of ratings quality would not nec-essarily be positive. Fear of liability could leadCRAs to become cautious to an extent that woulddistort ratings outcomes. As previously exposed,ratings represent probabilities, and therefore theidentification of individual ratings mistakes mayprove to be inextricably difficult.

8 Reduced regulatory reliance on ratings

As many policymakers and CRA executives

themselves17

have noted, it is desirable toeliminate references to ratings in contracts andregulations, in order to prevent pro-cyclicality inthe financial system. Efforts have beenundertaken in this direction, by both the privateand public sectors18. However, in some cases thereare no easy alternatives at hand. In contracts,replacing third-party ratings with an opinion oncreditworthiness emanating from the contractualparties themselves can create legal uncertainty.In regulations, eliminating ratings results in

shifting the burden of creditworthinessassessment either to regulated entities, with arisk of poor analysis or self-serving manipulation,or to public authorities, with the risk of making the

Regulation of CRAs by the Securities and Exchange Commission did not prevent the subprime

debacle. Europes regulatory screws on CRAs are already quite tight, and full implementation of

the existing regulations would be warranted before envisaging their further tightening.



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19. IOSCO published anupdate of this code in 2008.

20. The US Dodd-Frank Actled to amendments to Regu-

lation FD, but without sig-nificantly affecting CRAs

access to non-public infor-mation (Moodys, 2010).

21. An example is the ESMAStatement on disclosures

related to sovereign debt to

be included in IFRS financial

statements, European Secu-rities and Markets Author-

ity, 28 July 2011.

assessment more vulnerable to political oropportunistic considerations.

Efforts to reduce the reliance of contracts and reg-ulations on ratings should be pursued. However,some reliance on ratings is likely to remain as incertain cases it might remain preferable to anyavailable alternative arrangement. In its Principlesfor Reducing Reliance on CRA Ratings, the Finan-cial Stability Board concludes cautiously that incertain cases, it may take a number of years formarket participants to develop enhanced riskmanagement capability so as to enable reducedreliance on credit rating agencies (FSB, 2010).

9 A global regulatory/supervisory regime for CRAs

To the extent that credit ratings are useful, theircomparability across borders is a global publicgood in the context of international financialmarket integration. The risk of fragmentation dueto regulatory differences was minimal before thecrisis, as only one major jurisdiction (the US)materially constrained the behaviour of CRAsthrough regulation. Now that the EU, Japan, India,

Australia, Hong Kong and other jurisdictions havestarted to regulate CRAs, however, there is anincreasingly material risk of different regulatorsimposing different standards resulting in a reduc-tion of cross-border ratings comparability.

A constructive step to address this risk would bethe adoption of global standards that would deter-mine the content of jurisdictional regulationsapplicable to CRAs with the aim of maximum har-monisation. The International Organisation of

Securities Commissions (IOSCO) would be the log-ical forum for the discussion and preparation ofsuch standards, as it has done in the past for lesshands-on regulatory approaches such as its 2004code of conduct fundamentals for CRAs (IOSCO,2004)19. A more radical initiative would be theestablishment of a global public (treaty-based)authority to which individual jurisdictions woulddelegate the supervision of CRAs, thus ensuringglobal supervisory consistency.

This proposal may sound overly ambitious ongrounds of national sovereignty, but it is to benoted that similar arguments were long madeagainst the establishment of European

supervisory authorities in the financial sector,which were eventually superseded with the

adoption of the EU financial supervisory packagein 2010. The continued global integration offinancial markets may require unprecedentedsteps of international supervisory cooperation,and CRAs are arguably one of the categories ofregulated market participants for which suchefforts could be considered most necessary.

10 Increased public transparency from issuers

Last, but by no means least, more could be done toreduce the role of CRAs by better empoweringinvestors and the wider public to make their ownjudgments on issuers creditworthiness. This couldbe achieved through a significant increase ofpublic disclosure requirements on issuers, and acorresponding reduction of CRAs access to non-public (privileged) information. Such an effortwould take different forms in the different seg-ments of the credit ratings market:

Structured credit: ideally, the assets underly-ing structured securities should be described

in detail to investors so that the CRAs that ratethem do not rely on any privileged information.Some steps have been taken in this directionsince the start of the crisis, but more remainsto be done.

Corporate issuers: new regulations could pre-vent CRAs from accessing non-public informa-tion as they currently do with issuers, in amanner similar to what is already in place forequity analysis (Regulation Fair Disclosure inthe US20, and the Market Abuse Directive in the

EU). Simultaneously, issuers should berequired to disclose more standardised andaudited information about their risk factors andfinancial exposures. This is especially true offinancial institutions. The EU banking stresstests of 2010 and 2011 have illustrated thebenefits of such transparency for establishinginvestor trust, and some of the disclosuresimposed on stress-tested banks in the July2011 exercise could be made a permanentrequirement. In practice, this may be achieved

through a combination of accounting disclo-sure requirements (IFRS and related ESMAstatements21) and prudential standards (underthe Basel Accords so-called Pillar Three).



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Sovereign issuers: in this segment particularly,better public disclosure could go a long way

towards reducing the gatekeeping role of CRAs.Government accounts and risk disclosures are notwell standardised and can be highly unreliable asthe 2009 Greek episode has shown. A coordinatedinternational approach towards better standardi-sation and more robust verification processeswould be highly desirable, including major stepstowards the generalisation of accrual accountingby governments as has already been tried in anincreasing number of countries22.

Our constantly developing financial system needsbetter risk assessment than CRAs have beencollectively able to deliver in recent times. Morecomprehensive public disclosure by issuers on

their financial risks, which would not requireintermediation by CRAs, is the best chance for

new and better risk assessment methodologiesand practices to emerge23. To put it in a simplisticbut concise way, what is needed is a John Moodyfor the twenty-first century24. CRAs themselvescan perhaps be somewhat improved by adequateregulation and supervision, but public policyinitiatives that focus only on CRAs are unlikely toadequately address the need for substantiallybetter financial risk assessments. If real progressis to be made towards a better publicunderstanding of financial risks, it will have toinvolve innovative approaches that even well-regulated CRAs, on the basis of recent experience,may not be the best placed to deliver.

22. International PublicSector Accounting Stan-dards (IPSAS) have beendeveloped since 1997 byan autonomous boardhosted by the InternationalFederation of Accountants(IFAC). They have beenadopted by a limitednumber of countries so far,as well as a handful of inter-national institutions includ-ing the EuropeanCommission.

23. See Vron (2009) for amore detailed developmentof this argument.

24. To the extent that JohnMoody, the founder ofMoodys, can be consideredthe inventor of credit rat-ings as we know them, andwhich he started publishingin New York in 1909.

REFERENCES

EFAMA, ESM and IMA (2008) Asset Management Industry Guidelines to Address Over-Reliance uponRatings, European Federation of Asset Management Associations, European Securitisation Forum,and UK Investment Management Association

European Commission (2011) Roundtable on Credit Rating Agencies: Summary of points raised inthe roundtable, Directorate General Internal Markets and Services

European Parliament (2011) Credit rating agencies: future perspectives, non-legislative resolution,8 June

FCIC (2011) The Financial Crisis Inquiry Report, US Financial Crisis Inquiry Commission, PublicAf-fairs, New York

FSB (2010) Principles for reducing reliance on CRA ratings, Financial Stability Board

IOSCO (2004) Code of conduct fundamentals for credit rating agencies, International Organisationof Securities Commissions

IMF (2010) The Uses and Abuses of Sovereign Credit Ratings, chapter 3 of the Global Financial Sta-bility Report, International Monetary Fund

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Rate Expectations- What Can and Cannot Be Done About Rating Agencies (English)

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