Regulation does not favour consistency

With the advent of the GFC the cry went out from some investors (and even a few politicians) about the need to do something about the credit rating agencies.

After all, they stuffed-up and, through reckless ratings of collateralised debt obligations, were one of the agents of the sub-prime crisis that morphed into the GFC.

There is no doubt that when it came to rating CDOs, as well as sub-prime mortgaged backed securities and other complex structured finance products, the agencies got it wrong.

So now regulators around the world, including the US Securities and Exchange Commission, European Commission and ASIC, are scrambling to impose tighter controls on the operations of the agencies.

The three dominant ratings agencies are Standard & Poor's, Moody's Investors Service and Fitch Ratings.

But in doing so, are the regulators trying to turn credit ratings into something akin to a guarantee, rather than an opinion?

And of course there is also the attendant risk of unintended consequences, which seems all too real in this case, as will be discussed further below.

However, upfront it is worth pointing out that the consumers of credit ratings, primarily institutional investors, have the power in their hands to control the performance of, and influence, the ratings agencies.

If institutional investors believe the agency analysis is incorrect and the credit ratings assigned misleading, then they should ignore them and rely on their own credit risk analysis.

Institutional investors should remember that the agencies need to fight for their attention and respect. Without that, the agencies' ratings are worthless and they don't have a business.

As for unintended consequences, it was reported last week that ASIC wants the local ratings agencies to ratify ratings issued offshore on securities that are to be sold in the Australian market. ASIC also wants independent directors appointed to local boards.

While this is in line with proposals recently put forward by the European Commission, clearly regulators are seeking some measure of control over agencies within their jurisdictions.

However, this is akin to protectionism and putting up barriers to free trade in global markets. It will certainly hamper the operation of global financial markets.

One of the key strengths of credit ratings and the methodology of the agencies is their global consistency in the application of credit ratings. The agencies have worked hard to achieve this and continue to do so through the various review committees that examine the consistency of ratings around the world.

This ensures that a AAA rating in Australia is the same as one in the US, Europe, Japan etc. In this sense AAA is AAA.

Once local variations are introduced this consistency is destroyed. It is effectively a move back to what is referred to as national rating scales.

National rating scales are not globally consistent and to date have been used to provide granularity of credit ratings at a national level, where implementation of the normal global scale would result in a bunching of credit ratings at the bottom end of the scale. National rating scales provide useful relativity for comparing national entities.

Moreover, national rating scales are typically used in emerging markets. In these markets local rating agencies often claim a particular expertise in understanding the 'special' features of their domestic market and entities.

It is here that companies that would struggle to make investment grade on a global rating scale can be rated AAA by a local rating agency.

While it is not the intention of regulators such as ASIC to create national rating scales in this sense, the move to have local ratings can open the door for subsequent pleadings by interested parties.

The move to have more control over local credit ratings seems to be a move towards providing more of a guarantee on the credit quality of the locally rated entity or security. But there needs to be  recognition by all concerned that credit ratings are an opinion, not a guarantee.

Opinions cannot be regulated, though regulators can possibly act to ensure that the methodologies used are rigorous and globally consistent. Nevertheless, the greatest asset of the ratings agencies is their reputation and credibility, which, if lost, will destroy their business, as mentioned above.

The agencies proved that they are poor at rating complex structured finance products. Their approach to rating sub-prime mortgage backed securities was not sufficiently rigorous and their models for assessing other more complex products were inadequate.

By virtue of this, their opinions on these products should now be viewed as being of little value and the market should effectively withdraw the agencies' 'licence' to rate such products. This will open the door for new specialist structured finance ratings agencies to enter the market.

This seems a better approach than more regulation and the unintended consequences that could result.