Financial Reform: Why credit the rating agencies?

Ilene Grabel

The credit rating industry is firing from both barrels.  The industry has launched a public relations effort that aims to delegitimize proposed regulations announced for public comment last month by the US Securities and Exchange Commission (SEC). The proposed regulations stem from the Dodd-Frank Act of 2010. At the same time the industry is taking its hubris to new levels by inserting itself aggressively and directly into public policy debates in the US and Europe.

This is a rather stunning reversal of fortunes for the rating agencies.  In the early days of the financial crisis, it looked as if the industry was in for a fundamental overhaul. At that time, it seemed that there was momentum in the US around the creation of a new rating industry model—in the new model they would operate as public utilities. Elsewhere in the world, discussion of the failings of this industry was part of broader conversations about the need to move away from a US-centered financial architecture. In Europe and Asia, in particular, the misdeeds of the rating industry led to calls to create new regional and/or national entities that would credibly and ethically perform this work.

An overhaul of the rating industry was long overdue. The current crisis made it simply impossible to paper over the industry’s multiple failings.  These include, but are not limited to, the conflict of interest that is an intrinsic feature of a business model wherein those whose securities are being rated pay for their ratings. Moreover, the industry’s analysts and the models they use have consistently failed to assess sovereign and private risk accurately. There is a revolving door between analysts and the entities that they rate. The structure of the industry means that rating firms have incentives to build business by offering more lenient ratings than their competitors. And the monopoly power of the industry is maintained by the fact that some entities (such as insurance companies) can only invest in assets that are rated, and these ratings must be performed only by firms that the SEC designates as nationally recognized statistical rating organizations.  And though the report by the US Financial Crisis Inquiry Commission (a Congressional panel) was disappointing in so many respects, it did correctly indict the credit rating industry, calling its three biggest firms “essential cogs in the wheels of financial destruction.” 

With all of this, there was reason to assume that the industry would face serious restructuring.  But its officials and supporters managed to lobby their way out of serious change under Dodd-Frank. Having won the major battle, industry spokespeople are now pushing back hard against all of the proposed new regulations that the SEC proposed last month. The SEC’s proposals do not get at the heart of many of the key problems that characterize the industry. But they are at a step in the right direction, and so should be imposed on an industry that has escaped all responsibility for a crisis to which it contributed so mightily. The regulations would mandate that rating firms periodically test the competence of their employees, strip references to credit ratings in securities offerings, prohibit rating firm analysts from issuing a rating if they also marketed their firm’s products or services, and would require that firms examine whether a former analyst awarded overly generous ratings to a firm that later hired that person. The SEC is also studying the issue of whether it should create an independent body that will assign performance ratings to raters, another initiative that is being opposed aggressively by the industry and Republicans.

At the same time as the industry is pushing against these rather modest regulations, it is working hard to elevate its role in the global economy.  The industry has long exploited its falsely claimed role as neutral judge and oracle on matters of economic and social policy across the globe. These roles are reinforced whenever the firms announce downgrades, threats of downgrades or changes in what they call “the outlook.”  Such decisions can and have helped to empower politicians and the business lobby since they are treated as serious evaluations of whether a country’s economic policies render a sovereign default more or less likely.  All of this matters because a threatened or actual downgrade means that a government has to pay more to borrow money. This is because when investors become convinced that there is a greater risk of sovereign default they will lend money to the government (i.e., buy its bonds) only if they are compensated for this perceived higher risk via a higher interest rate. Other interest rates in the economy generally rise accordingly. 

The credit rating agencies have been quite busy lately downgrading countries and also threatening to do so. For example, despite the humanitarian and economic challenges of the Japanese nuclear disaster at Fukushima in March, Moody’s announced earlier this month that it might downgrade its debt rating for Japan, joining S&P and Fitch in taking a more pessimistic view of the country’s economy. In the end, Moody’s kept its rating for Japanese bonds constant, but said its review of the rating for a possible downgrade had been prompted by  “heightened concern, that faltering economic growth prospects and a weak policy response would make more challenging the government’s ability to fashion and achieve a credible deficit reduction target.” Without an effective strategy, the rating agency said, government debt “will rise inexorably from a level which already is well above that of other advanced economies.” The Japanese government noted that it was disappointed, but that it was nevertheless forced to take the threat seriously. 

The raters have been notably effective in injecting themselves into the debate over the US debt ceiling.  Moody’s warned last week that it might downgrade the US government’s perfect credit rating if Congress did not increase the nation’s debt limit in the “coming weeks,” a message that seemed to appeal to both Democrats and Republicans looking to reinforce their position that their opponents are forcing the country into a financial Armageddon. Moody’s said pointedly that whether the US keeps its AAA rating “will depend on the outcome of negotiations on deficit reduction.” Fitch Ratings has since made a similar announcement. These warnings followed a similar one from S&P in April, when it lowered its outlook for the US credit rating (but did not lower the rating itself).

As the European crisis has contaminated the southern part of the continent, the region’s economies have been buffeted by a repeated chorus of pronouncements by the raters. For example, the rating firms seem to be in a new competition with one another that involves regular downgrades and threats of future downgrades for Greece and Portugal (and formerly for Ireland).  Indeed, earlier this month Moody’s lowered Greece’s sovereign rating so that it sits even deeper within the category that the rating firms label as “junk.”  These downgrades arrive when Southern Europe faces unprecedented political turmoil and social conflict over reductions in public spending and rising taxes, all against the backdrop of devastatingly high unemployment. 

The industry has gone even further than it has in the past by positioning itself above elected governments, between political movements and against civil society groups. The positions taken by the industry in these national contexts not only undermine democratic debate over fiscal policies, but also threaten economic recovery by empowering those forces that see economic and other crises as the ideal time to roll back social spending and dismantle welfare states.

It boggles the mind that the credit rating firms are not taking a standstill on pronouncements in Europe, Japan and the US while conditions are so fragile. It also strains the imagination that the firms are still claiming that they are being unfairly targeted for regulation.  The industry’s recent efforts can only be read as a campaign to protect the industry’s global influence and profits.  Let’s hope that civil society actors intensify their campaigns to expose the failings, corruption and undue influence of this delegitimized industry. 

For more on rating agencies, see Triple Crisis Blogger Kevin P Gallagher’s post in The Guardian, The Tyranny of bond markets.