The rating agencies have lots of problems, but they are not to blame for the financial crisis. The regulators and investors are the ones who deserve the blame. The agencies have too much influence, but it’s been given to them by the regulators.
The latest round of anti-rating agency sentiment was sparked by “unfair” downgrades of banks or even move “unfair” downgrades of countries. Does it really make a difference what the agencies do? It shouldn’t. Nothing about that action changes anything about the state of the economies, or our debt loads, or our deficits. The agencies have no inside information when it comes to sovereign, and I suspect minimal when it comes to other entities. There is only one reason that ratings are market moving – because the regulators have made it so. If it wasn’t for regulations based on ratings, the power and influence of the rating agencies would drop immediately.
Regulators Give the Rating Agencies Irrational Power
Not only do the regulators provide the rating agencies with great influence, but they also do it in an irrational manner.
A quick look at Basel II shows that a AA- sovereign has 0 risk weighting, but at A+ it carries a 20% risk weighting. That jumps to 50% for BBB+. Is a AA- entity really that much lower risk than an A+. For corporates corresponding risk weightings are 20%, 50% and 100% respectively. In the real world risk does not jump like this. There are not discrete points where risk spikes up. So at the very least the framework should be gradual. It also creates an incentive for people to fight over single notches. Getting a A- rating is dramatically different than getting a BBB+ rating according to the regulators. Does anyone out there really believe that the agencies are so good that they are accurately distinguishing between A- and BBB+? I think they can barely tell A from BBB let alone single notches. In the grand scheme of things, it wouldn’t matter, except the regulators have placed this power in their hands.
It’s not just banking regulators that have taken this bizarre approach. The NAIC has a similar ratings based methodology complete with a big step function when ratings breach thresholds.
More sophisticated institutions can use their internal models rather than rating agency models for determining capital. It is done with the approval of the regulators. I can guarantee you that banks don’t choose to use their own models when it gives a higher capital requirement than using the rating agency based one.
Rating agencies are at the bottom of the Wall Street food chain. I could spend a long time trying to justify this claim, but we only have to look at things that matter to Wall Street to prove this. The Wall Street pecking order can easily be determined by looking at pay and job envy.
Q) Who pays more, investment banks or rating agencies? A) Investment banks.
Q) How many people at the rating agencies wish they had a job at one of the banks whose deal they are rating? A) Everyone, except for the one long timer who has convinced himself that the extra stress at a bank wouldn’t be worth the piles of extra money.
Q) How many people on the deal team wish they were working at a rating agency? A) None, except for the occasional first year associate who hasn’t yet figured out how good he or she has it.
Investors Need to Do Their Own work and Regulators Need to be Conservative
Clearly Europe is trying to get rid of rating agencies to be aggressive, but the situation has to change. For too long, laziness has driven regulatory policy. Too much emphasis has been put on ratings, and the safety at the high end has been dramatically exaggerated. One thing virtually every banking crisis has in common, is when a previously “safe” or AAA asset, that carried minimal capital charges deteriorates. The sub-prime mortgage market and European Sovereign debt are just two of the most recent examples.
We need a realistic regulatory framework like the one we discuss in regulatory-capital-size-and-how-you-use-it-both-matter.
Anyways, what the EU is doing is probably even worse than the existing framework, but the idea of diminishing the role of rating agencies is a good one.