End the Credit Rating Addiction

IMF Blog, September 30, 2010

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Credit ratings measure the relative risk that an entity such as a government or a company will fail to meet its financial commitments.
In theory, credit ratings serve an incredibly useful role in global and domestic financial markets by aggregating information about credit quality and adding liquidity to otherwise illiquid markets.
Agencies named as the main providers: Standard & Poor’s, Moody’s, and Fitch.

Overreliance on ratings by borrowers, creditors, investors, and regulators contributed to financial instability.
Ratings became "hardwired" into rules, regulations, and triggers:
- Central banks often use ratings in their collateral acceptability rules.
- The Basel II standardized approach to determining bank capital requirements relies heavily on ratings.
- Institutional investors—pension funds, insurance companies, retirement funds—often have rules that trigger sales when securities are downgraded below certain levels.
Mechanical reliance creates feedback loops:
- Abrupt downgrades and even pre-downgrade warnings can prompt deleterious selloffs of securities.
- Market reactions often occur when warnings are released rather than when the actual rating changes, triggering domino effects and broader spillovers.
Sovereign ratings sometimes failed to account adequately for debt composition and contingent liabilities; in some cases (Greece cited) rating agencies lacked access to all necessary information.
Not all investors have equivalent in-house capacity for risk assessment; smaller and less sophisticated institutions remain heavily dependent on third-party ratings.

Regulators should reduce their reliance on credit ratings.
Markets need to "end their addiction to credit ratings."
Credit ratings should be one of several tools to measure credit risk, not the sole or dominant one.
Increasing oversight of the main rating agencies is warranted where their ratings continue to play key regulatory roles (for example, under the Basel II standardized approach).
Policymakers should push rating agencies to improve procedures related to transparency and governance to provide greater assurance that ratings are fairly constructed.

Remove mechanistic use of ratings in rules and regulations; some countries have begun this process.
Persuade large investors to perform their own risk assessments as part of buy/sell decisions.
Differentiate the process of reducing reliance on ratings according to the size and sophistication of institutions and the instruments being rated.
Subject agencies whose ratings play key regulatory roles to increased oversight (both oversight and differentiation approaches were included in the recently signed U.S. financial sector reform legislation).
Encourage countries to prepare and make publicly available a fiscal risk statement to improve information available to rating agencies.
Continue reform efforts that aim to "wring out the volatility, without drying up the liquidity" provided by ratings.

Authored by John Kiff; September 30, 2010 — IMF blog entry "End the Credit Rating Addiction".

CHApTER 3 tHe uses and aBuses oF sovereIgn credIt ratIngs
- CHApTER 3 tHe uses and aBuses oF sovereIgn credIt ratIngs (Markdown version)
- CHApTER 3 tHe uses and aBuses oF sovereIgn credIt ratIngs (PDF)