That the ratings industry survived the global financial crisis intact, with the top three - Moody's, S&P and the smaller Fitch - having 95% of the market share, is a damning indictment of the financial market regulatory system. Worse still, since 2000, the top two firms stocks have vastly outperformed the S&P 500, with the growth being vertiginous since the GFC.
It is fair to argue that credit rating agencies have played a critical role in facilitating lax lending and the deluge of corporate bond issuances since the GFC, itself caused, among others, by their own indiscretions. With central banks now purchasing corporate bonds, their importance as credible gatekeepers has soared.
A recent article in The Economist draws attention to the re-emergence of ratings inflation, which was a major contributor to the GFC,
A report by the OECD in February found that agencies gave borrowers more leeway on leverage, relative to earnings, in 2017 than a decade earlier.
The article also highlights this out about ratings,
In a working paper, Edward Altman of New York University finds what he calls “an over-rating problem” just above junk. Based on analysis of a batch of metrics including leverage, liquidity and sales, he concludes that over one-third of corporate debt that was on the bottom investment-grade rung going into the pandemic should have been at least one grade lower. In other words, it was junk in all but name. This bears on the most pressing question facing rating agencies today: what to do about the more than $3trn of corporate debt rated triple-B, on the precipice above junk. In 2010, 45% of all investment-grade debt was in this bottom tier; now it is just shy of 60%.
An OECD study found that downgrades from triple-B to junk are rarer than those elsewhere on the ratings spectrum, suggesting that agencies may be reluctant to force borrowers across that Rubicon. An alternative explanation is that firms make particularly strenuous efforts to avoid such a demotion, to so-called “fallen angel” status, aware that it can mean a sudden spike in borrowing costs.
In other words, an important source of the incentive distortions associated with rating agencies may be in the lowest tier of investment grade rating, both in rating a security afresh and in its periodic assessments.
Needless to say, if a forensic analysis of the ratings in this tier is taken up, it could uncover countless cases of unscrupulous practices and outright fraud.
This calls for a particular focus on assets rated in this tier. Some of the well-known rating reform proposals could be prioritised for this tier.
1. Limit the possibilities for ratings shopping. Accordingly, instruments being issued by this tier could be mandated to be rated by multiple agencies. Or issuers could be mandated to have such issuances by a firm rated by a rotating pool of an expanded set of 7-8 rating agencies. Or they could be issued by a financial market body which collects fees from everyone and get the ratings done.
2. Ensure rigor in reassessments. The ratings in this tier should be subjected to a greater rigour in surveillance and re-assessments. How about mandating re-assessments by another rating agency?
The regulators too could keep track of the various market trends to identify ratings inflation. The trends in the break-up among the different ratings categories over a business cycle, both for the market (or market segment) as a whole and for individual rating agencies. Or particularly, the share of triple-B ratings in the ratings basket of an agency.
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