A new approach to rating?

Over the past few years, ever since the financial crisis began to unfold, there’s been sporadic talk in the media and among politicians of the need to reform the credit rating agencies. These agencies are doing a terrible job at forecasting their clients’ futures, and yet their ratings can have catastrophic effects on financial markets and on vast swathes of the world economy. Clearly something needs to change here.

The entrepreneur Roland Berger recently announced that a new rating agency is to be established in Europe in order to provide competition with the prominent American rating agencies which currently have so much influence over the European economy: Moody’s, Standard and Poor (S&P) and Fitch. Could this be the beginning of a different approach to rating?

Apparently the main difference between the existing agencies and the new one is that it would be held legally responsible for its analyses. That means that if it got something wrong its clients could claim damages.

At first glance this might seem like an improvement. Last summer, S&P downgraded the US’s rating and justified their decision partly on the expectation that the country’s debt to GDP ratio would increase at a certain rate. But they made a mistake in their calculations, throwing them off by around 2 trillion dollars. The agency apologized when this error became known but they didn’t change the rating and their mistake didn’t seem to have any effect on their credibility. So if a mechanism were in place whereby a client could claim damages from S&P in those circumstances, that might be considered a good thing.

But in fact it isn’t at all clear that matters would improve.

For one thing, according to reports on the proposed new agency, the only party that would be able to claim damages from it would be the client, ie the company or country that is rated, rather than the investor. So the conflict of interest which is notoriously inherent to the current system, encouraging the agencies to over-rate their clients so that they get paid generously, would remain inexorably in place.

Indeed, there might actually be an even stronger incentive than there is now for the agencies to over-rate their clients. That’s because the type of rating that rating agencies do is very different from the rating of, say, hotels or B&Bs. With hotels, the proprietors may be perfectly happy to only get a rating of one star since – depending on their location – there might be market demand for that type of hotel. A low rating may even be what they are aiming for.

But nobody wants their financial products to get a low rating as that makes it much harder, and more expensive, for them to sell. Moreover, given the financial markets’ jitteriness, nobody even wants to give the impression that they think they deserve a low rating. So under the proposed system the clients would be likely to feel driven to challenge any low rating, even if it’s justified, in order to make it appear as though their company is sound. Conversely, if they got an unrealistically high rating they would have no incentive at all to challenge it.

So many of the problems which contributed to the current financial crisis, with wildly over-rated financial institutions contributing to a bubble economy, would remain completely unaddressed and it’s possible instead that the new agency would quickly become bogged down in endless lawsuits initiated by irate clients who consider themselves to have been under-rated – or at least, claim that they feel that way.

So the answer to our question about whether the new agency will improve matters is “probably not”. Its dependence on payment from the same people as are getting the ratings is likely to prove a fatal flaw.

That’s unfortunate, but not very surprising. Indeed, in its press release about the new agency, Berger’s company unintentionally caused me some amusement when it said that the initial funders include “very broad representation of the European financial services industry, with banks, insurance companies and institutional investors all involved in the founding consortium. That will unquestionably strengthen the credibility of the new institution”. I wouldn’t be so sure that everyone will be filled with confidence at the news that the big European banks are participating en masse.

And that’s only one problem with the current rating setup. There are many others. For example, there are significant flaws in the assumptions agencies make when they actually do their rating. Alain Frachon comments trenchantly in Le Monde that rating is “a mixture of figured estimations and ideological assumptions, following your nose and holding up a finger to the wind”.

We can see a glaring example of this if we return for a minute to the under-rating of the US economy by S&P last year. Many observers, including most politicians apparently, assume that while S&P were wrong in their analysis the basis on which it was made was fine: it’s perfectly appropriate to judge countries’ financial soundness according to the size of their deficits.

But in fact there’s enormous controversy over this. Quite a few prominent economists, among them Paul Krugman, Joseph Stiglitz and the proponents of Modern Monetary Theory, follow the Keynesian idea that high government spending is often necessary in a recessionary economy and that government debt is of an entirely different nature to personal or business debt.

And the flaws in the current system of rating go deeper. Anyone familiar with the ideas on this website, or with those of organisations with similar philosophies to ours such as the New Economics Foundation and the Positive Futures Network, will know that we challenge two very pervasive mainstream assumptions: that continual economic growth is possible and that it’s an accurate measure of progress and success.

Of course these assumptions are widely held and we can hardly single the agencies out for blame about them. But if we bear in mind that rating agencies are supposed to be “forward-looking” and “assess the potential impact of foreseeable future events”, it begins to seem a little odd that they apparently give no weight at all to social stability and have even gone so far as to directly undermine it in the Middle East. And then there’s the matter of energy use and general environmental impact. It’s hard to see how these factors couldn’t have an effect on clients’ financial stability, yet they seem to be completely ignored by the agencies.

So what should be done?

Given these types of problems – both structural and ideological – we might well wonder whether rating agencies actually play any constructive role in the economy. Should they just be abolished?

Some commentators, such as Alain Frachon, think that the existing rating agencies should have been closed down after 2008 when it became clear that they were incompetent. But he also recognises that this would have been difficult to do, because the ratings have come to form a vital part of government investment regulations about things like pension funds (which are only allowed to buy highly-rated stocks and bonds). Moreover, borrowers are legally required to get themselves rated by the agencies: they’re well woven into the system. The US is currently in the process of extricating itself from that particular tangle, and Europe obviously needs to do the same.

That won’t solve everything, though. Governments and other investors need some kind of firm basis for making investment decisions – and a true alternative to the current rating system hasn’t really been mooted. Even if the investors and borrowers do away with their formal dependence on rating agencies there’s a real danger that they’ll simply continue to make the same assumptions about investment stability and trustworthiness as the rating agencies do.

So what alternatives might there be? I’ll be suggesting a few in a follow-up post to this one, which should go online within the next couple of weeks, and would welcome comments about them.

Featured image: The Vision of the Last Judgement by William Blake

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