Banks Required To Rely Less on Ratings Agencies

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Banks Required To Rely Less on Ratings Agencies

Since 2010, the ECB has been trying to break banks reliance upon credit rating agencies. In 2011 Jean-Claude Trichet ranted and raved against the influence of Moody’s, S&P, and Fitch. In 2012 Mario Draghi recommend directly for banks to pay less attention to credit ratings agencies. To emphasize the point the ECB went as far as to conduct a study of these credit ratings agencies (CRA) and found that the CRA’s provided more favorable ratings in return for continued customers. The conflicts of interest compromised the CRA’s and incentivized the CRA’s to provide more favorable ratings to some issuances than they should have. The ECB has also gone so far as to commission studies on alternatives to issuer paid CRA’s.

The results were not good.   Many have tried to start non issuer paid CRA’s and found a series of problems including: insufficient demand, insufficient resources, and very poor implementation. A second notion popped up. “Skin-In the Game”- in short making the ratings agencies purchase those securities it rates as investment grade. This too ran afoul of both ability and logic. With what money would the CRA purchase those investments other than additional charges for the ratings? One gimlet eyed observer also commented, “Do you think it adds yet another level of conflict of interest to allow the agencies to game their own ratings in order to either deflate the value of a future bond purchase or inflate the value of the bond after acquisition?

It appears as a last resort the ECB has ordered that banks do their own assessments and to rely less upon just what the CRA’s provide.

There is a collection of problems of which this directive is the proximate casue. Assume the bank has deduced that a bond issue is in much better shape than the CRA would lead you to believe. Will the ECB allow the bank to use the better internally rated bond but poorly agency rated bonds to shift the bond from Tier 3 to Tier 2 capital on the bank’s balance sheet? Will the bank face liability if it buys lower rated bonds for a client’s portfolio because they think the ratings agency had it wrong? How can an analysis in a bank or even a department of annalists in a bank have more information and have access to long developed and refined rating algorithms possess by the CRAs? How can they, with any bit of intellectual credibility, ‘out rate’ or ‘out time’ the professional ratings agencies?

I am not a fan of the big rating agencies. There is just too much fiscal sausage and client chicanery going through them to make much sense out of their ratings alone. Furthermore, if a company is not a big company there is a strong correlation that their debt issues will be rated as junk. Michael Millikan knew this. He used the asymmetric information of lazy CRA’s poor ratings of smaller companies versus looking – actually looking – at a company’s balance sheet and performance. It was the delta caused by the slop of the CRA’s systemic failures to accurately rate smaller companies. Milliken made a tidy profit on the knowledge arbitrage. The smaller ratings agencies such as Kroll and the regional agencies seem to do a much better job than the big guys as they are closer to the risk and the markets, but do they carry as much gravitas with the regulators as the big CRAs?

So, how does a bank, an insurance company, a mutual fund, out guess the ratings agencies?

The only safe bet for those regulated by the ECB is to find issuances the CRAs have over rated and short them. Their is no long side play that the ECB could tolerate as I read the rules and the ECB advice.

I understand the need not to repeat the errors of the past decade, but requiring the banks to discount or ignore the advice of experts is akin to telling a cancer patient to discount the knowledge of their medical doctor and listen to their ill informed second cousin.

This is not due diligence, this is not wise.

A better choice is for the ratings agencies to either share how they rate issuances and be freed from liability except for intentional acts, or to allow the courts to hold them liable for their failures.

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