Now Moody’s has put the UK’s sovereign credit rating on negative watch, it means a downgrade is in sight. The UK government puts great store by the opinions of credit rating agencies. But recent experience suggests that an actual downgrade should have little financial significance. France and the US lost their triple A ratings without too much damage to their finances.
The reputational crisis of Credit Rating Agencies (CRAs) is ongoing and is putting into question whether CRAs are playing a credible role in Eurozone financial markets. The current Eurozone crisis supports the proposition of scepticism on the credibility of CRAs which did not properly disclose risks and thus contributed to pushing the global financial system to the verge of collapse. Politicians across the European Union have called for restrictions on the role of CRAs in rating sovereign debt and for increased regulation of CRAs.
In the US the credit rating agencies have been hiding behind the First Amendment. Their legal argument is that they cannot be held accountable because they are merely issuing “opinions”. However, this defence is breaking down and not valid outside the US in any case. Calls are increasing for mechanisms to hold CRAs accountable.
Experience during the financial crisis has heightened concerns that CRAs decisions may be subject to conflicts of interest. Since rating agency revenues are predominantly driven by rating fees earned from issuers, there is a concern that CRAs devote disproportionate resources to chasing new business and rating new products, rather than on improving their analysis of existing instruments. Furthermore, the revenue incentives of a CRA are such that ratings may be biased upwards (inflated) so as to meet an issuer’s expectations and thereby gain or keep their business.
The operational rigour of the CRAs is also in question. Standard & Poor’s, for example, caused a major upset with its recent erroneous downgrade of France. The agency’s notification went out on 10 November 2011 just before 4pm Paris time when the European markets were still open. Its “opinion” thrust a knife into “containment”. The yield for France’s 10-year bond jumped 25 basis points to 3.48% and the spread between 10-year French and German bonds hit 1.7%, a Euro-era record. Standard & Poor’s waited two hours to issue a correction, after the European markets had closed; it issued a terse, 65-word ‘clarification’. “As a result of a technical error …. We are investigating the cause of the error,” it said in a non-apology to a furious French government.
Mark Froeba, who was a senior vice president at the time he left Moody’s after 10 years of employment, testified before the US Federal Crisis Inquiry Commission on 2 June 2010. “When I joined Moody’s in late 1997, an analyst’s worst fear was that he would contribute to the assignment of a rating that was wrong, damage Moody’s reputation for getting the answer right, and lose his job as a result. When I left Moody’s [in 2007], an analyst’s worst fear was that he would do something that would allow him to be singled out for jeopardizing Moody’s market share, for impairing Moody’s revenue, or for damaging Moody’s relationships with its clients, and lose his job as a result.”
This change in corporate culture, one that eventually prioritized company profitability over corporate integrity, has been attributed to Moody’s Corporation going public in 2000 after a split with its holding company Dun & Bradstreet. This led to two specific changes that arguably influenced corporate culture: First, after the company went public, senior managers were compensated in the form of stock options for the first time in company history. Second, the nature of taking a corporation public forces a company to worry about profitability on a quarterly basis. This pressure to please shareholders may have forced Moody’s to prioritize short-term quarterly reports of profitability over ratings integrity.
A recent new draft report from the European Parliament Economic and Monetary Affairs Committee has proposed giving the European Union sweeping regulatory powers that include the right to ban sovereign credit ratings if countries do not want them. The European Parliament draft report will be used in negotiations over legislation for the European Union will also calls for recommendations on setting up a fully independent public European Credit Rating Agency.
Other proposed changes could include a provision to reduce excessive reliance on credit ratings by removing from European Union laws all references to the need for ratings for regulatory purposes. Banks, insurance companies and other financial institutions would have to make their own credit risk assessments without relying solely on credit ratings. “No rating outlook should be published with respect to sovereign debt,” the document adds. “This implies that their ratings should be treated as information to be taken into account, but that agencies should not themselves enjoy special status or automatically influence the activities of economic and financial operators and public institutions.”
The European Parliament Economic and Monetary Affairs Committee report will almost certainly be amended before it becomes the official position of the European Parliament Economic and Monetary Affairs Committee on 21 May 2012 and then will be voted on by the European Parliament. Then it will be used as the basis for negotiation with the European Commission and the European Council, where the national governments meet. The European Parliament has equal legislative rights to the other institutions. The CRAs, financial actors and some national governments are likely to lobby hard to tone down the European Parliament draft report through amendments. Do we need CRAs with their poor prediction record and business model that contains conflict of interest and a lack of due diligence? The lack of their value and usefulness has become apparent over the last fifteen years. Yet it still seems that market players are addicted to these organizations. If we have to accommodate them in the near future, there is a need to encourage private sector initiatives to create new CRAs in order to increase competition and diversity in the market.