In defense of credit rating agencies
Fif ten years back in August 2008, the world’s credit unions were in one of the worst periods in their history. The global financial crisis was about to reach its peak. It was already clear that the loyalty of rating agencies – which was to both investors and debt issuers – had crossed a healthy limit. The survival of their business model seemed uncertain.
In turn for the books, rating agencies have had more. Lenders’ requests to mark their homework have increased. During the market boom in 2021, Moody’s Investors Service, one of the “big three agencies”, made almost $4bn in revenue, compared to $1.8bn at its peak in 2007. The “issuer pays” business model, in which lenders operate. the hook for their own rated bonds, creating a conflict of interest for the groups, has also yielded, despite endless demands for change. But although they have gone largely unreformed, assessment bodies have been working well in recent years.
Ironically, ranking groups often come to light when they are so important. That’s what happened on August 1 when Fitch, another of the big three, lowered the American government’s rating from aaa to aa+. After all, no group offers better expertise when it comes to analyzing the fiscal health of rich countries. The economic data they see is widely viewed by everyone else. In 2015 US money market funds were freed from using credit ratings as their sole metric for deciding whether to invest in securities. Money can now certify, for example, that a security represents “minimum credit risk”. This means that a downgrade to a Financials rating is even less important than before.
However, rating companies have two important roles. First, they collect, sort and publish information about lenders, which investors can search and use to compare them. Second, they act as a stamp of approval on assets. Bank regulators use credit ratings to determine the capital requirements for borrowers; money uses them to decide what they should and shouldn’t keep.
Evaluation agencies have a difficult job: not to attract negative attention about a result as good as they could reasonably expect. During the deep financial distress early in the covid-19 pandemic, they quietly managed just that, as concluded by the Committee on Capital Markets Regulation, a panel of researchers from academia, banking and business , when they were evaluating their performance later. In 2020, 198 companies were ranked by s&p Global Ratings, the largest number since the global financial crisis, is gone. Although 11 investment-grade companies failed to repay their debt in 2009, all defaults in the first year of the pandemic occurred among companies that were already classified as speculative-grade. more dangerous.
The companies participated in the collapse of Silicon Valley Bank (etc) in March. Both Moody’s and s&p which gave etc investment grade levels. But the bank’s downfall, enabled by social media, instant messaging and digital financial apps, was swift. And the rates given to the bank – of a3 and bbb respectively – far from the highest notes available. Indeed, a downgrade warning from Moody’s the previous week etcCollapse was one of the reasons that revealed the bank’s financial situation. Rating agencies can be criticized for being asleep at the wheel, or for fueling the crisis, but almost both.
Research also shows that agencies continue to play a role in rating emerging market government debt. One paper by the Bank for International Settlements, a club of central banks, shows that rating changes continue to have a significant impact on credit default swap markets in the emerging world, suggesting that investors respect the judgments of organizations. Another, published by the World Bank, estimates that the impact of credit ratings may have increased even since the global financial crisis. A one-notch improvement in the credit rating of a developing economy relative to similar countries raised capital inflows of about 0.6% of gdp in 2009-17, about a third more than in the previous decade.
Rating agencies are a lightning rod for criticism. Companies that try to be risk adjusters end up getting things wrong – or worse, playing a causal role – during an unexpected blowout. Even though the problems that emerged during the financial crisis are still unresolved, rating agencies are still vital to the functioning of the capital markets. Recently, they have even been doing a good job.■
Read more from Buttonwood, our financial markets columnist:
Meet America’s Hidden Property Investors (August 3)
Investors are gripped by optimism. Can the bull market last? (July 25)
The dollar’s decline will not become a permanent decline (July 20)
Also: How the Buttonwood column got its name