The role of credit-rating agencies from a central banker s perspective

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1 SPEECH DATE: SPEAKER: LOCALITY: HANTERINGSKLASS: Stefan Ingves Stockholm Centre for Commercial Law ÖPPEN SVERIGES RIKSBANK SE Stockholm (Brunkebergstorg 11) Tel Fax registratorn@riksbank.se The role of credit-rating agencies from a central banker s perspective The combination of law and economics is particularly important to society. From an economist s point of view, legal texts are the packaging technology by which economic arguments can be turned into policy. One challenge is of course to create legally-sound texts that incite the desired behaviour of economic agents. The field of credit rating and credit-rating agencies constitutes a fascinating intersection between law and economics. Over the past few years, regulators worldwide have also worked hard to implement new legislation aimed at improving the quality of credit ratings and thus the efficiency of financial markets. Today, I would like to discuss the role of credit-rating agencies from a central banker s perspective. As you are all aware, we central bankers are concerned with financial stability and credit ratings are important from a financial-stability perspective. To begin with, I would like to discuss why credit-rating agencies are important to financial markets and to society as a whole. I would also like to discuss what we can expect from the various players on the credit-rating market; rating agencies, investors and regulators. Secondly, I will present some empirical examples of how credit-rating agencies have performed over time. Finally, I will give my opinion on some current issues related to credit-rating agencies. Credit-rating agencies are important for financial markets Many banks and other financial institutions are both large and complex. This makes it difficult and costly for lenders to evaluate the creditworthiness of a bank. This task is especially difficult for ordinary depositors. Credit-rating agencies therefore perform a service to society as a whole by providing credit opinions on financial institutions. In addition, the credit-rating industry is characterized by economies of scale which makes it more efficient that a smaller number of players specialize in performing credit-risk assessments. 1 [6]

2 Credit-rating agencies provide information How can we then define the role of credit-rating agencies on the financial markets? I would say that the role of rating agencies is to provide information to market participants. The information asymmetry surrounding the credit quality of an institution or asset is not much different from the market for lemons described in Akerlof s classic article from Borrowers know much more about their own credit quality than lenders. Unless investors can distinguish between borrowers with a high credit quality and those with a low credit quality, they may not be willing to provide funding on more favourable terms to the good borrowers. This could drive high-quality borrowers out of the market and lead to a lower equilibrium level of investment than if information on the credit quality of borrowers was known. When credit-rating agencies provide accurate information on the credit quality of borrowers, the price of credit can reflect that quality and overall market efficiency can improve. Especially for smaller market participants with a limited capacity to perform their own credit-risk assessment, external credit ratings can be an important source of information on counterparties and investments. For smaller issuers, acquiring a credit rating from a well-known rating agency can also be an important tool for signalling creditworthiness and for getting access to market funding. Investors remain responsible for the investment decision Irrespective of the usefulness of the credit opinion of rating agencies, investors should not rely exclusively or mechanically on credit-rating agencies. Ultimately, market participants remain responsible for the decision to invest in a certain asset or to lend to a certain institution. This also means that market participants must understand the credit quality of their investments and exposures. Although it is reasonable that credit-rating agencies can be held responsible for serious mistakes, this should never shift the responsibility for the investment decision from the investor to the rating agency. Only if the investor is fully responsible for the decision to lend money will he or she do it prudently enough and the problem of moral hazard can be avoided. Today, many large financial institutions rely significantly on their own internal models for assessing credit risk. There is currently a challenge, especially for small and medium-sized institutions, to find the right balance between relying on external credit ratings and performing one s own credit-risk assessment. Regulators ensure transparency and accountability Until recently, the regulation of the credit-rating market was almost nonexistent. However, in the aftermath of the recent global financial crisis, the importance of the supervision of financial institutions has come to the fore. The growing reliance on credit-rating agencies in global financial regulation also justifies a certain regulatory monitoring of the quality of their ratings. Therefore, regulators have a role to play in setting standards for the accountability and transparency of the rating process and the resulting ratings. In the EU, a 1 Akerlof, George A. (1970). The Market for Lemons : Quality Uncertainty and the Market Mechanism. Quarterly Journal of Economics (The MIT Press) 84(3): [6]

3 first regulation 2 of credit-rating agencies entered into force in 2009 and additional regulation is currently under negotiation. A potential conflict of interest One of the major issues that has called into question the credibility of creditrating agencies is their remuneration model. In the past, rating agencies were principally paid by investors, whereas today they are to a large extent paid by the rated institutions themselves. This raises the question of whether creditrating agencies act in the interests of those who invest the money or those who borrow the money? There is a potential conflict of interest here since the issuer has an incentive to choose the credit-rating agency that provides the highest rating. This may cause credit-rating agencies to issue higher ratings than warranted in order to win business. This in turn is not in the interests of investors who want the most accurate credit assessment. However, this potential conflict of interest is somewhat mitigated by the fact that credit-rating agencies depend on their reputation. Issuing credit ratings that do not reflect the underlying credit quality may not be a sustainable business model in the long run. Still, it is relevant to further clarify the question of on whose behalf creditrating agencies act. One method could be to require additional transparency regarding the relationship between the credit-rating agency and its clients. Increased transparency concerning the nature and size of the business relationship would allow market participants to make their own assessment of any potential conflict of interest. It is also important that credit-rating agencies are transparent with respect to the rating methodologies and information each credit rating is based on. This transparency will help market participants in assessing and comparing credit ratings. Empirical examples of credit-rating agency performance Obviously, there is a preference for credit-rating agencies to provide ratings that are not only accurate but also forward-looking. However, any agency that makes many credit judgements over time will sometimes make mistakes. The probability of misjudgements is particularly high in periods when the economy is moving from one state to another. Let us now discuss a few examples of the performance of credit-rating agencies over time. The Swedish economic policies of the 1980s laid the foundations for the problems that surfaced in the early 1990s. However, during the 1980s, Sweden s AAA credit rating did not suffer despite the growing fiscal deficit and falling competitiveness. Our credit rating was only revised downwards when the longrunning economic problems became acute in In 1995, the Swedish debtto-gdp ratio peaked at almost 80 per cent and our credit rating was three steps below AAA. But, I would say that by then we had already solved the major economic problems and laid the groundwork for the sound and competitive 2 Regulation (EC) No 1060/2009 of the European Parliament and of the Council of 16 September 2009 on credit-rating agencies. 3 [6]

4 economy Sweden is today. Nevertheless, it took us more than 10 years, until 2002, to go through the cycle and regain our AAA status. In this period, I was myself working at the Swedish Ministry of Finance, which dealt with the credit-rating agencies. The rating downgrades came in spite of some attempts to convince rating agencies that the Swedish economy was in good shape. In retrospect, the assessment made by the rating agencies was in my view not unreasonable. The credit-rating events that we now see in southern Europe are somewhat similar to what happened in Sweden in the early 1990s. If we examine the credit ratings of the most severely-indebted countries in southern Europe, we can see that not much happened for quite a while despite growing external imbalances and fiscal deficits. Suddenly, over the past few years, there has been a significant downward shift in sovereign ratings. Of course, now there are more and larger countries involved, which provokes a more intense debate about the credit-rating process. The same pattern of rating developments can also be found for structured products during the most recent financial crisis. For a period of almost 30 years, there was only a very small number of credit-rating downgrades on the US structured finance market. Suddenly, as the subprime crisis hit the US economy in 2007, the number of rating downgrades skyrocketed 3. Meanwhile, the investment bank Lehman Brothers retained the relatively high credit rating A until its failure in September Of course, these dramatic shifts in credit ratings over the recent financial crisis have caused some tension among investors who buy the rating information on which they then base their investment decisions. We can without doubt say that credit-rating agencies bear some responsibility for not being fully as forward-looking and good at assessing risks as we would wish. This might also be because when the world has been stable for a long time, we tend to believe that it will continue to be stable. Long periods of stability also risk creating complacency and reduced alertness to signs of change. In reality the state of the economy can change rapidly and managing this transition is difficult. The sudden large revisions of credit ratings provide an example of the challenge of adjusting from one state of the economy to another. Current topics related to credit-rating agencies Different types of AAA Another more specific topic I would like to take up is the issue of the comparability of ratings across different asset classes. Credit-rating agencies provide ratings of many different entities such as sovereigns, financial companies and non-financial companies. Ratings can be long-term or short-term, and in domestic or foreign currency. In addition, there are specific ratings of complex products such as covered bonds and asset-backed securities (ABS). Obviously, credit-rating agencies use very different methodologies for rating the various issuers and products. For example, the methodology for rating a 3 See Benmelech, Efraim and Dlugosz, Jennifer (2010), The Credit Rating Crisis, NBER working paper. See also BIS Committee on the Global Financial System (2008), Ratings in structured finance: what went wrong and what can be done to address shortcomings? CGFS Papers No [6]

5 country is vastly different from the methodology for rating a structured product such as an ABS. Given that the credit rating of a country reflects very different qualities compared to the rating of an ABS, a relevant question is whether the AAA rating of a structured product can be compared with the AAA rating of the Kingdom of Sweden? In general, we must be careful in comparing ratings across market segments. There could also be some merits to using different rating scales for the various market segments to underline the fact that their credit quality may not be easily comparable. Reduced reliance on credit-rating agencies in the regulation Finally, let me comment on some of the recent regulatory initiatives concerning credit-rating agencies taken by the Basel Committee on Banking Supervision and the Financial Stability Board, both of which I am a member. Nowadays, credit ratings form part of many laws, standards and regulations. However, there is a risk that the regulatory endorsement of ratings as a standard measure of credit risk will lead market participants to rely too much on credit-rating agencies. In October 2010, the Financial Stability Board published a set of principles for reduced reliance on external credit ratings in standards, laws and regulations. The principles aim at improving financial stability by reducing the herding behaviour that can arise when investors act upon external credit ratings that are hard-wired into regulations and market practices. They also aim to create incentives for investors to perform more of their own credit-risk assessment. In the Basel Committee on Banking Supervision, we are also in the process of analysing how to reduce reliance on credit-rating agency ratings under Basel III, for example when assigning regulatory capital. External ratings have been an important component of the calculation of regulatory capital for credit risk, particularly in the case of small financial institutions that use the standardised approach. However, as pointed out by the Financial Stability Board, references to external ratings should only be removed from the regulation once alternative solutions have been found and can be safely implemented. The challenge of finding reliable and all-encompassing alternative measures of credit risk implies that we are likely to see references to external credit ratings in the regulation for some time to come. The continued reliance on external ratings makes it even more important for regulators to monitor the quality of credit ratings 4. Proposal for an EU rating agency A proposed solution for improved competition in the credit rating-industry, that has been discussed in Europe on several occasions, is the creation of an EU credit-rating agency. There are two main reasons why such an EU rating agency would fail to serve its purpose: First, any official-sector involvement in the rating process may create the illusion of government endorsement of the credit rating. This may cause market 4 Irrespective of the quality of credit ratings, the financial regulation itself has to adequately address credit risks. For example, the European Capital Requirements Directive, did not require any regulatory capital for holding domestic currency sovereign debt. This provision did not create the right incentives for euro area banks to manage sovereign credit risk. 5 [6]

6 participants to increase, rather than reduce, their reliance on external credit ratings. Second, although such a European credit-rating agency would be formally independent of any government, it is likely that it would be subject to political pressure that could come through funding or the appointment of board members. If this in practice would result in states rating other states, the ratings issued would not be credible. Concluding remarks Let me conclude by saying that this conference on credit-rating agencies comes at a very good time. We have recently seen changes in the economic and financial landscape, resulting in a major revision of credit ratings for many types of institutions and assets. We have responded to this shift by calling for improved regulation of the financial sector in general, including credit-rating agencies. A discussion of the effects of the new regulation of credit-ratingagencies can now begin and any required amendments can be defined. The time we have taken here to reflect further on the challenge of improving the quality of credit ratings and the possible way forward is therefore time well spent. 6 [6]