Upgrade, Downgrade: Time To Question The Value Of Cras?

France's and Italy's recent credit downgrades ignited criticism not just from disgruntled politicians but from European central bankers too. In chorus with Mario Draghi of the ECB Mervyn King recently expressed the need to "pay less attention to the verdicts of rating agencies". Such expressions of discontent intimate deeper, existential concerns about the function and impact of rating agencies within the current global economic framework: what are they really here for and do we really need them? Theoretically, credit rating agencies (CRAs) are supposed to reduce what's known in the jargon as "information asymmetries". By providing independent information on all manners of securities they put lenders and borrowers on a level footing. This stops issuers of assets misleading other financial entities about the quality of financial products they are selling, in turn reducing costs and risks for firms who don't have to spend lots of money researching each financial instrument they purchase. CRAs therefore reduce what is called the "principle-agent problem". Here is a simple analogy: if I (the agent) want to borrow money from you (the principal) to invest in some-such project it may be in my interest to pretend that I am credit worthy and that I will definitely pay you the money back. I promise to pay you the interest back with the huge gains I will supposedly make from the investment. Thanks to my formidable persuasive abilities and your ignorance of my poor income prospects and credit history, you lend me the money. However, if a credit rating agency had been present it would have made the principal (you) more fully aware of the sticky mess you are about to get into by scrutinising the expected profitability of the investment, my credit history and so on. These checks are time consuming and far too costly for you to carry out. So does this work in practice? The reality is somewhat counterintuitive. Controversially, CRAs operate on an "issuer-pays" basis. This means that the issuer of the security pays the rating agency itself! In the lead up to the financial crisis all sorts of investment banks were paying the CRAs (mainly S&P's and Moody's) to get ratings on hugely toxic products they themselves were issuing. And what ratings were these financial weapons of mass destruction blessed with? AAA. There are two reasons for this. Firstly, the financial assets were simply too complicated for the CRAs to analyse rigorously. Secondly, the issuer could always threaten to go and pay another CRA if it didn't get the rating it wanted. The ensuing financial crisis exposed these ratings as mistaken and hugely optimistic. These considerations cast a dark shadow over the informational value CRAs actually impart to the market. Conflict of interest or not, CRAs failed to do their job. What about Sovereign entities? Surely CRAs aren't wrong about the debt positions of countries like Italy and Greece? Of course not, but this highlights the same sort of problem; CRAs aren't imparting any new information to the market. Bond markets don't need to be told that Italy and Greece have serious debt problems by CRAs. Yield spreads between German and Greek 10 year government bonds (a market measure of risk) started increasing before credit rating agencies made successive downgrade announcements. That said, a recent working paper by the ECB has documented the tendency for CDS spreads (another market measure of perceived risk - the higher the spread, the higher the perceived risk) on EU countries to increase significantly after rating downgrades, but not to change much at all after upgrades. Rating downgrades therefore do have a significant impact on the market in negative scenarios, but is this really because credit rating agencies are telling the markets anything new? My suspicion is no. The fact is that many contracts, rules, accords and regulations require that banks and institutional investors, like insurance funds and pension funds, hold pools of "good quality", externally rated assets. The Basel ii accord, for instance, requires that banks hold a certain quantity of AAA rated assets if they want to be allowed to maintain a specific capital ratio. If these assets get downgraded, in order to maintain the capital ratio, banks have to sell these assets. Technicalities aside, the overall effect is that downgrades lead to sales of assets that happen by a more or less automatic process. The sales are not a result of investors being much more enlightened about the situation. In fact, so long as credit ratings remain a structural part of the financial system in this way they can destabilise markets even more; a rating downgrade causes institutions to sell assets which raises borrowing rates which further reducing countries' abilities to service their debt which could then lead to a further downgrade and so on and so on and so on. Viewed in this light, depending on the extent to which institutions are contractually reliant on credit ratings, downgrades can be inherently destabilising. Finally, despite its draw backs, at least one advantage of the "issuer-pays" system by which CRAs operate is that they can acquire information about the entity issuing the securities that the market can't by interacting with the issuer directly. The CRAs have no such intimate lines of communication with Governments. Moreover, the extent to which the Italys and the Greeces of the Eurozone will pay back their debts depends largely upon future political factors that are unknown even to the most influential European political figures. Are we really to believe that CRAs, through their all-seeing crystal ball, have some better way of divining knowledge about the political future than anyone else does? A concerted examination of CRAs and the role they have to play in the financial system is long overdue.