Rating Agencies: Why the Fuss Is Overdone
Ever since the financial crisis hit in 2008, the issue of the rating agencies has come up again and again. And yet: there has been little in the way of reform. This is for two reasons: one, there has been a lack of promising suggestions for replacing the current setup; and two, much of the hullabaloo has been overdone. The reason: the structure of the rating market itself is its most attractive attribute.
It's true: rating agencies are paid by the very people they rate. If this seems like an area for a potential conflict of interest, it's because it most certainly is. Producers and providers in competitive markets have to compete for customers by giving the customers what they want. There's just one catch here: the rating market is uncompetitive. It is, in fact, an oligopoly.
Oligopolies represent one of the three market failures (cure: anti-cartel authorities). The other two are one-sided information (cure: laws requiring transparency and information sharing) and externalities, which are goods or services that are either enjoyed by many but paid for by few or vice versa (cure: usage restrictions/regulations and externality charges). The rating market is oligopolistic, which is bad for consumers of its products. The good news: the direct consumers of its products are banks and its products are ratings, used by everyone and paid for only by the banks (a positive externality it makes sense to maintain).
Standard and Poors (S&P), Moodys, and Fitch, the big three ratings oligarchs, do not really have to compete very much for customers. Securities almost have to be rated by at least one of them in order for them to even have a chance of being traded, and many or most are rated by two or more, especially by S&P and Moodys. This puts the Big Three in a position of power. They do not have to offer better ratings for higher prices. In fact, doing so would be pretty much the only thing that could damage them because it would damage their credibility.
So why is their credibility already so damaged? Their ratings were horrendously inadequate and had not been adjusted to the new instruments that have been coming to the market over the last 15-20 years. They failed because of poor modeling and a system in need of updating (ratings are based mostly on past credit performance), not (or at least, not usually) because of collusion with the banks they were supposed to rate. The agencies now have every incentive to reform because their most valuable asset, their credibility, is at risk.
The rating agencies are likely to last, however, because there is no real alternative! Out of disgust over "speculative attacks" on Greece and Portugal after rating agencies downgraded both countries' debt (due to very real fears the countries may not be able to pay lenders back), European leaders recently stated their intention to create a European rating agency. As Austrian commentator Eric Frey put it, "That a European rating agency is called for in this particular situation illustrates that such an agency would be stillborn. If a rating agency has to first ask (French President) Sarkozy and (German Chancellor) Merkel before lowering a rating, no one will ever take it seriously."1 It's not like government agencies did such a bang-up job protecting the economy from the crisis, nor did most experts anticipate the full extent of the crisis. Why should we expect some new goverment-run agency to do better, especially one that is politically compromised?
Is there scope for reform? Probably, on the micro scale. Perhaps agencies responsible for giving ratings could steadily rotate and other things could be done to prevent cronyism, etc. (author's note: I just saw that a proposal for rotation has actually been made that would include a provision for using the accuracy of agencies' ratings to decide how many future ratings they give. Has someone in Washington been reading my blog?). Still, even this is no guarantee - ratings work well until they don't, as this crisis has shown all too well. Our greatest comfort is still that the ratings market is so uncompetitive. Perhaps we could do with a less competitive baking sector as well? Or at least one that values debt and risk less highly for systemic, not personal, reasons?
It's true: rating agencies are paid by the very people they rate. If this seems like an area for a potential conflict of interest, it's because it most certainly is. Producers and providers in competitive markets have to compete for customers by giving the customers what they want. There's just one catch here: the rating market is uncompetitive. It is, in fact, an oligopoly.
Oligopolies represent one of the three market failures (cure: anti-cartel authorities). The other two are one-sided information (cure: laws requiring transparency and information sharing) and externalities, which are goods or services that are either enjoyed by many but paid for by few or vice versa (cure: usage restrictions/regulations and externality charges). The rating market is oligopolistic, which is bad for consumers of its products. The good news: the direct consumers of its products are banks and its products are ratings, used by everyone and paid for only by the banks (a positive externality it makes sense to maintain).
Standard and Poors (S&P), Moodys, and Fitch, the big three ratings oligarchs, do not really have to compete very much for customers. Securities almost have to be rated by at least one of them in order for them to even have a chance of being traded, and many or most are rated by two or more, especially by S&P and Moodys. This puts the Big Three in a position of power. They do not have to offer better ratings for higher prices. In fact, doing so would be pretty much the only thing that could damage them because it would damage their credibility.
So why is their credibility already so damaged? Their ratings were horrendously inadequate and had not been adjusted to the new instruments that have been coming to the market over the last 15-20 years. They failed because of poor modeling and a system in need of updating (ratings are based mostly on past credit performance), not (or at least, not usually) because of collusion with the banks they were supposed to rate. The agencies now have every incentive to reform because their most valuable asset, their credibility, is at risk.
The rating agencies are likely to last, however, because there is no real alternative! Out of disgust over "speculative attacks" on Greece and Portugal after rating agencies downgraded both countries' debt (due to very real fears the countries may not be able to pay lenders back), European leaders recently stated their intention to create a European rating agency. As Austrian commentator Eric Frey put it, "That a European rating agency is called for in this particular situation illustrates that such an agency would be stillborn. If a rating agency has to first ask (French President) Sarkozy and (German Chancellor) Merkel before lowering a rating, no one will ever take it seriously."1 It's not like government agencies did such a bang-up job protecting the economy from the crisis, nor did most experts anticipate the full extent of the crisis. Why should we expect some new goverment-run agency to do better, especially one that is politically compromised?
Is there scope for reform? Probably, on the micro scale. Perhaps agencies responsible for giving ratings could steadily rotate and other things could be done to prevent cronyism, etc. (author's note: I just saw that a proposal for rotation has actually been made that would include a provision for using the accuracy of agencies' ratings to decide how many future ratings they give. Has someone in Washington been reading my blog?). Still, even this is no guarantee - ratings work well until they don't, as this crisis has shown all too well. Our greatest comfort is still that the ratings market is so uncompetitive. Perhaps we could do with a less competitive baking sector as well? Or at least one that values debt and risk less highly for systemic, not personal, reasons?
- Eric Frey, "Zynischer Kampf gegen Windmühlen," Krisenfrey (blog), 8 May 2010, http://derstandard.at/1271376262183/Blog-KrisenFrey-Zynischer-Kampf-gegen-Windmuehlen.
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