Tuesday, December 06, 2011

Belshaw's World - ratings madness

The global credit rating agencies have become a cancer eating away at the global economy.

In the lead-up to the global financial crisis, they gave triple A credit ratings to institutions and securities that were clearly not. As the crisis unfolded, the variations they made to country and institutional rankings added to market instability.

We see the same thing today in the unfolding crisis with the Euro.

The credit rating agencies provide no new information to the market. The standard of their economic and financial analysis is clearly suspect. Yet despite all this, a shift or threat of a shift in a county’s credit rating can have damaging or even catastrophic market effects even though it tells us nothing that we didn’t already know.

Our problem and it is our problem because it affects us all, lies in the way that we have awarded the ratings agencies authority without responsibility. We have created a cancerous monster.

We have had to work quite hard to achieve this.

Looking back into a now dim and distant past, I remember discussions in the Commonwealth Treasury on the possibility that Australia might get a triple a credit rating for the first time. We did, lost it in 1986, then finally got it back in 2003.

Australia’s original concern with its credit rating at state and Federal level made a lot of sense.

In those days, both State and Federal Governments borrowed to fund infrastructure. We needed access to global capital for both private and public purposes. A high credit rating made it easier for a small relatively remote country like Australia to access funds and at a lower cost.

From being a means to an end, the maintenance of a triple A credit rating became an end in itself. All Australian Governments preached this as a badge of honour.

There was a certain irony in this shift, for it coincided with a fundamental shift in Government funding patterns. Australian Governments largely stopped direct borrowing, thus reducing the direct gains associated with the triple A rating.

One can argue whether or not Australian obsessions with triple A rating were justified. One can also argue about the use of so called private-public partnerships to shift apparent borrowing to the private sector, thus increasing borrowing costs.

What can be said with some justice, however, is that the obsession with the maintenance of a triple A rating did provide some degree of fiscal discipline, something that would be important during the global financial crisis.

So far, so good. However, at this point a fundamental change occurred in the approaches adopted to the ratings agencies, one that would have devastating consequences. In simple terms, their credit rating role became institutionalised.

Take Australia as an example. As part of the deregulation process, local government was given greater freedom to invest surplus funds. Further, there was an expectation that local government would manage their funds so as to get the best return, thus benefiting rate payers.

Under previous arrangements, investments were restricted to a prescribed list of asset classes. Now, local government had greater freedom to invest so long as the securities in question had the appropriate rating from the ratings agencies.

I have used an Australian example, but this type of change took place around the world in both private and public sectors. The ratings as awarded by the agencies were built into a myriad of regulations, financial arrangements and associated contracts.

This institutionalisation created a fundamental conflict of interest in the agencies themselves, for they made the majority of their money from fees charged for ratings. More importantly, it gave the agencies a role that they could not in fact properly fulfil.

We saw the results of this during the global financial crisis when agency rated triple A securities proved to be, at best, junk status. However, there was another even more pernicious effect.

The institutionalisation of agency ratings, their incorporation into so many regulations and arrangements, meant that variations in credit ratings had direct flow on market effects in ways that no-one had foreseen. The ratings system itself had become a direct cause of market instability and on a large scale.

At this stage, it is very hard to see just how all this can be unwound. Yet we need to do so if global economic problems are to be properly addressed.

Note to readers: This post appeared as a column in the Armidale Express on 30 November 2011. I am repeating the columns here with a lag because the Express columns are not on line. You can see all the columns by clicking here for 2009, here for 2010, here for 2011.

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