There is a need for what credit rating agencies do in the fast, furious and often opaque world of modern finance and investment.
The big three Fitch Ratings, Moodys Investors Service and Standard & Poors provide a valuable service opining on the creditworthiness of borrowers, whether thats the US government, a Latvian bank or a Mongolian fluorspar miner.
However, the need for credit ratings has rapidly grown into an unhealthy and often destructive reliance by market participants. Indeed, the judgment calls of the main agencies have been seen to have systemic consequences, as the credit crisis showed. Regulators have tried to tackle the agencies power, but their efforts have been in vain.
Ultimately, their influence stems from being enshrined in financial regulation, and a vast array of markets practices and financial contracts to boot. Leading institutional investors, for example, are restricted to buying securities rated only by the big three agencies its the law. Borrowers are therefore compelled to have a rating to sell their bonds to investors. In short: no rating, no deal.
For banks and insurers, traditionally only assets rated by the big three can be used to calculate capital requirements again, its the law. Therefore, removing ratings from regulation should reduce the agencies power. However, the reality is that ratings would continue to be relied on because they are so ingrained in investment, banking and capital markets culture.
The question then becomes is there any way to break this cultural dependence? Short of enforcing ratings prohibition, which will never happen and neither should it some answers are emerging.
For institutional investors, and particularly the smaller institutions, one simple answer is ensuring they carry out their own credit analysis and use ratings as only one input of many they should involve when investing. Thats difficult to enforce, particularly in Europe, where it is often argued investors lack the credit-analysis skills of their US peers.
In addition, explicit references to ratings in investment mandates restricting investors to holding only highly rated securities by the big three could be adjusted, or perhaps even eliminated. This is something regulators are tackling. There are, however, risks with doing that, not least removing something that is designed to protect end-investors.
In the capital markets and for centuries before the rating agencies existed governments, financial institutions and companies raised funding by selling bonds to investors who had come to their own judgement on the borrowers creditworthiness. Today, there are some signs this is happening again.
Unrated international bond issuance from borrowers with globally recognized brands is, while still small, on the up. A debut unrated bond from Louis Dreyfus Commodities this month is a case in point. And look closely in regional or domestic capital markets and this trend is gathering pace. After all, local investors have an intimate knowledge and understanding of local issuers and therefore there is less need for a rating.
And in banking and insurance regulation, where the use of credit ratings is perhaps most pervasive, there is perhaps a simple solution simplifying capital rules. This is something the Bank of Englands Andrew Haldane alluded to in his Jackson Hole speech in August.
Specifically, some argue that a return to simpler capital rules could be one way to remove the use of ratings.
A return to static ratios would eliminate errors in judgment arising from ratings changes. However, determination of the ratios would be a big point of contention.
Another possible alternative could be market-linked capital charges. This approach would rely on the market to determine the level of capital an institution must hold to support an asset. Instead of a credit rating, the market price would be used to gauge the assets risk profile. However, this is just as contentious.
Stripping the rating agencies from regulation doesnt necessarily clip the power they have over markets, but its a step in the right direction to ultimately creating a system that relies less on them. Even the big three agencies claim to want that.