What Remains to be Done?

The responsibility borne by credit rating agencies (CRAs) for the financial crisis has been analyzed in depth by policymakers and various expert groups over the last eighteen months. Some of the proposed reforms went much further than the changes set out in the European Union Regulation on Credit Rating Agencies. Expectations of the Regulation's impact should therefore not be unduly high. Policymakers are well aware of this and see the Regulation's primary objective as being to address the problem of conflicts of interests. As things stand, there is a good chance that this can be achieved.

Given the limited scope of the selected approach, however, it is clear that it can only make a qualified contribution to stabilizing the financial system, namely in areas where the instability has been caused by conflicts of interests or general corporate governance problems. Key issues, such as the lack of competition in the ratings market, liability, and, above all, the procyclical impact of credit ratings, remain unresolved. It would go far beyond the scope of this paper to present detailed proposals for their solution. Instead, these concluding remarks will confine themselves to outlining which approaches appear the most promising from the perspective of the banks in Germany.

While we are unlikely to see any meaningful proposals on liability beyond emphasizing the importance of ensuring that every single rating issued is of the highest possible quality, this does not apply to the other two issues mentioned. True, there is no simple solution to either problem. Competition between CRAs is desirable as it encourages high-quality ratings and their continuous improvement. Promoting more competition will be far from easy, however. The obstacles to entering the market are clearly extremely high. But facilitating market entry by offering political support for a European credit rating agency, for instance, would do little to boost quality through competition. The same goes for political intervention in the form of rules requiring a certain proportion of ratings to be issued by national or regional CRAs.

One obstacle to more competition is the issue of who should pay for a rating. The current tight oligopoly is unlikely to be broken up under the existing “issuer pays” system because neither issuers nor CRAs have an interest in more ratings. Nevertheless, switching to an “investor pays” model should not in itself be expected to produce a quick fix. Whereas in the “issuer pays” model competition can lead to inflated ratings because the company chooses who should rate them, in the “investor pays” model there is a free rider problem, and it is not clear how the free market can resolve it. This dilemma could, however, be solved by decoupling the competition problem from the ratings market. The service required is an assessment of credit quality or the risk of default. A credit rating is only one of the instruments capable of performing this task. Credit default swaps, for example, fulfill a comparable function from an alternative starting point. If the relevant market is defined in this way, financial market regulation itself will automatically have a direct role to play in enhancing competition because by using ratings to regulate banks it contributes directly to the reduction in competition.

Registration as nationally recognized statistical rating organizations or external credit assessment institutions places CRAs in a position of unqualified authority as the central source of information about the creditworthiness of bonds and structured finance products. This makes it clear that the competition problem is directly linked to the extent to which the regulatory use of ratings has exacerbated procyclicality in the financial system as a whole. The problem cannot therefore be resolved by increasing competition solely between CRAs but, above all, by seeking alternative approaches to assessing risk for regulatory purposes and thus for the purposes of determining capital requirements. Such a strategy has the potential to gradually reduce the role played by credit ratings in regulating the financial markets. The need to reduce the dependency of regulations and supervisory practices on ratings is also seen by the US Treasury (2009).

A different three-step approach to reduce procyclicality has been proposed by the International Monetary Fund. As a first step, policymakers should have a good grasp of the risk inherent in credit ratings. “Ratings maps” can offer a template for policymakers to identify the different channels through which rating downgrades can lead to systemic risk. Second, policymakers will need to measure risks inherent in ratings once they are identified. A useful method to measure the systemic exposure to downgrade risk during boom cycles would be for regulators and institutions to stress test their balance sheet and off-balance sheet positions. And finally, systemic institutions that are vulnerable to abrupt ratings downgrades may have to hold more capital or liquidity buffers (Sy 2009).

Naturally, this call to seek alternative approaches to assessing credit quality is also addressed to investors. They should decrease their dependency on ratings by basing their investment decisions on a broader range of indicators. This could reduce the risk of ratings downgrades being followed by mass selling, write-downs, and additional capital requirements. The most promising indicators to consider would be those that reflect a deterioration in credit quality more swiftly than is the case with credit ratings.¹¹

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