GLOBAL FINANCIAL STABILITY REPORT
Reducing Role of Credit Ratings Would Aid Markets
By John Kiff
IMF Monetary and Capital Markets Department
September 29, 2010
- Credit ratings have become embedded in regulations, private contracts
- Downgrades can set off destabilizing knock-on effects, spillovers
- Ratings reliance should be reduced
New IMF analysis says that ratings have inadvertently contributed to financial instability—in financial markets during the recent global crisis and, more recently, with regard to sovereign debt.
The analysis, in the IMF’s Global Financial Stability Report, recommends that regulators reduce their reliance on credit ratings as much as possible and increase their oversight of the agencies that assign the ratings used in regulations.
Credit ratings, which measure the relative risk that an entity such as a government or a company will fail to meet its financial commitments, play a significant role in certifying the quality of investments in fixed-income markets.
Regulators, for example, rely on ratings in setting standards for securities that financial institutions hold. Institutions must hold less capital to buffer against losses on higher-rated assets than on lower-rated ones. Central banks often rely on credit ratings to determine what securities they will accept as collateral on loans to bank or other financial institutions.
Ratings play similar roles in private financial dealings, when securities are posted as collateral and private financial contracts often contain ratings triggers that end credit availability or accelerate a borrower’s credit obligation if a downgrade occurs.
In the case of sovereign debt, the IMF said in the report released September 29, the problem does not lie entirely with the ratings themselves, but with overreliance on ratings by market participants, coupled with deleterious selloffs of securities when they are abruptly downgraded— called “cliff effects.” The IMF says, however, that credit rating agencies have to shoulder some of the blame for these cliff effects, because they may pay insufficient attention to sovereign debt composition and contingent liabilities, though in some cases they do not have access to all the information they need.
The IMF report, which is part of the main Global Financial Stability Report to be released October 5, also emphasized that despite these issues, ratings serve a useful purpose. They aggregate information about the credit quality of various types of borrowers and their financial obligations, allowing such borrowers access to global and domestic markets, and enabling them to attract investment funds. The ratings add liquidity to markets that would otherwise be highly illiquid.
Although rating agencies have most recently been scrutinized because of their downgrades of sovereign debts, due to weakened government balance sheets, the IMF report noted other destabilizing knock-on and spillover effects of rating downgrades. For example, sudden sharp and frequent downgrades of structured credit products in 2007 and 2008 triggered large selloffs and dealt a crippling blow to financial markets (see chart). That caused many policymakers and market participants to question the rating agencies and their methodologies.
The major rating agencies—Fitch, Moody’s, and Standard & Poor’s—do not target their ratings to the specific probability that an issuer will default. Instead they seek to provide only relative rankings of credit risk—that issuers in a lower grade are more likely to default than those in a higher grade and less likely than those below it.
The IMF report finds that the rating agencies do a pretty good job meeting that goal. For example, all of the sovereign debt that has defaulted since 1975 had received speculative-grade ratings one year ahead of their default. In other words the defaulting debt was concentrated in the lowest credit ratings.
The rating agencies also aim to ensure that ratings do not change frequently, because users prefer to avoid the costs associated with frequent policy changes and investment decisions linked to ratings. The rating agencies minimize ratings changes by judging an entity’s ability to survive a cyclical economic trough (that is, “through the cycle”) and by additionally applying various rating-change smoothing rules.
But the IMF report says that these added smoothing techniques often have an opposite effect from what was intended. Typical smoothing rules sometimes merely delay inevitable downgrades that become more abrupt and cliff-like if the situation has continued to deteriorate.
The aversion to rating volatility relates to the myriad ways in which ratings are embedded in investment guidelines and eligibility standards for securities used as collateral or investment.
The “certification” role of ratings has been formalized in securities regulations and rules, and prudential financial system regulations, such as the internationally accepted standardized approach to calculating bank capital requirements known as Basel II. Moreover, the IMF report found that rating downgrades from investment- to speculative-grade led to a statistically significant widening of the spread between the yield on the rated instrument and the risk-free rate.
To reduce the potential cliff effects in spreads and prices that rating changes can trigger, the IMF recommends the elimination of regulations that formally link buy or sell decisions to ratings, as some countries already have done. The IMF report also says that cliff effects could be mitigated if rating agencies refrained from using smoothing rules that effectively delay rating changes.
Reducing rating overreliance will require better fundamental credit analysis by users, and it will be important that the authorities remain wary of unintended adverse consequences. Moreover, policymakers pushing to reduce rating reliance should recognize that smaller and less sophisticated investors and institutions will continue to use ratings extensively.
Authorities should also continue to push rating agencies to improve their procedures, including those related to transparency, governance, and the mitigation of conflict of interest. The IMF report said there have been many positive developments in this area, including those aimed at dealing with the conflicts of interest inherent in the way ratings agencies are compensated: by the issuers of securities.
Under the issuer-pay model, there are incentives for the issuer to shop for the highest rating. Although rating agencies want to maintain their reputation for producing accurate ratings, these are diluted by their certification role that has created a more or less “guaranteed” market for their ratings. However, the report concludes that reducing rating overreliance and the associated certification role will go a long way toward reducing the incentives for rating shopping.
■ Allison Holland, Han van der Hoorn , Michael Kisser, Sylwia Nowak, Samer Saab, Liliana Schumacher, and Ann-Margret Westin contributed to this story.