One of the earliest take aways from the global financial crisis was the importance of access to information for effectively functioning financial markets. And, in that regard, credit ratings can serve an incredibly useful role in global and domestic financial markets — in theory.
In practice, credit ratings have inadvertently contributed to financial instability — in financial markets during the recent global crisis and more recently with regard to sovereign debt. To be fair, the problem does not lie entirely with the ratings themselves, but with overreliance on ratings by both borrowers and creditors.
In one of the background papers for the Fall 2010 Global Financial Stability Report that I prepared with IMF colleagues, we recommend that regulators should reduce their reliance on credit ratings. Markets need to end their addiction to credit ratings.
Credit ratings should be seen as one of several tools to measure credit risk, and not as the sole and dominant one. Instead, credit ratings, which measure the relative risk that an entity such as a government or a company will fail to meet its financial commitments, have become hardwired into various rules, regulations and triggers. Central banks often use ratings in their collateral acceptability rules. The Basel II standardized approach to determining bank capital requirements relies heavily on ratings. And, many institutional investors–pension funds, insurance companies, retirement funds, and the like–have rules that trigger the sale of securities when they are downgraded below certain levels.
Yet, when investors, regulators and borrowers rely on credit ratings too mechanically, changes in ratings, particularly abrupt downgrades, can lead to deleterious selloffs of securities. Not only does this create the potential for broader spillovers, but the resulting declines in the prices of securities trigger further sell-offs. In other words, those notorious domino effects!
Actions by ratings agencies to “smooth out” or make changes in ratings less abrupt–for example, through a warnings ahead of a possible downgrade–may be intended to minimize disruptions. However, they we find that much of the market reaction occurs when these warnings are released rather than when the actual rating changes.
And, as events of the past year or so have highlighted, sovereign ratings could have taken better account of debt composition and contingent liabilities. However, in some cases–Greece for example–the rating agencies did not have access to all the information they needed. In that regard, the IMF encourages countries to prepare and make publicly available a fiscal risk statement.
Still, the real solution lies in reducing the reliance on credit ratings as much as possible. This should start with removing the mechanistic use of ratings in rules and regulations, which some countries are already beginning to do. Investors must be weaned off credit ratings too. Policymakers should persuade the larger ones, at least, to perform their own risk assessments as part of deciding what to buy or sell.
Realistically, of course, not all investors have the same ‘in house’ capacity for risk assessment. Smaller and less sophisticated institutions will have to continue to rely heavily on third-party ratings. So, the process of reducing reliance on ratings should differentiate according to the size and sophistication of institutions, and the instruments being rated. Also, agencies–the main ones being Standard & Poor’s, Moody’s, and Fitch–whose ratings continue to play key regulatory roles (as in the Basel II standardized approach) should be subjected to increased oversight. (Both of these approaches were included in the recently signed U.S. financial sector reform legislation.)
Beyond this, our paper recommends that policymakers should also continue to push rating agencies to improve their procedures, including those related to transparency and governance. This will provide more assurance to those that use ratings that they are fairly constructed. Credit rating agencies aggregate information about the credit quality of various types of borrowers and their financial obligations. The ratings they issue allow many of those borrowers to access global and domestic markets they would not otherwise have, enabling them to attract investment funds. As a result, ratings add liquidity to markets that would otherwise be highly illiquid.
Wringing out the volatility, without drying up the liquidity, is the goal of any effort to reform the credit ratings agencies that issue them.
Cross-posted from iMFdirect.