Gary Wright of B.I.S.S Research speaks about the demise of the rating agencies and how financial institutions should cope until the agencies redefine their business structure and role within the industry.
One of the key failures of the financial crisis has been the credit ratings bestowed on financial institutions by a few but powerful agencies, the days when ‘Triple A Ratings’ were a no brainer green light to do business have now gone forever. Who now believes that any rating is worth its salt?
The OTC derivatives market and the many other derivatives products were created in markets far from being transparent. No one could measure the global demand for OTC derivatives or the depth and breadth that they covered in financial markets so it is perverse that banks should set such store by credit ratings.
Most informed experts felt that the extended ‘Bull Run’ was increasing exponentially the exposure in OTC and there would be a day of reckoning. However it was almost impossible to know for sure how bad it was going to get.
The problem with OTC products is the unknown factor of who is exposed to what and by how much, no regulator or central bank could have known for sure what the real position was. Even more so in the international markets where global regulators only had access to branch information rather than joined up data from the holding company. Even though there was a genuine reason to be uneasy about the growing black hole, basically no one could prove or put their finger on the exact risk. We are learning the hard way now!
It was amazing that ratings agencies were issuing their ratings which were maintaining the credit profile of banks, when the underlying feeling in the market was that some banks were getting into troubled waters. What were the rating agencies basing their ratings on? If it was only published data they were actually light years from reality.
In OTC derivatives markets nothing is more important than the credit ratings of those that are acting as counterparties or investors. All firms operating within the OTC supply chain will be taking aspects of the risk. The more OTC derivatives are overlaid upon the original transaction this further dilutes the collateral for margins. Indeed each margin becomes less of an overall percentage the more OTC transactions are dependent upon each other. A bit like robbing Peter to pay Paul. Thus the reliance on credit ratings was a real risk, as it turns out and one that will need attention as the market begins its recovery process.
Many banks were in error as they put an over reliance on third party ratings which were created from processes that were not audited and never transparent. The historical positioning of credit rating agencies within the industry supply chain has bred an over confidence in the management of counterparty risk.
People that have grown their careers in the finance industry have been unquestioning, just accepting that credit ratings are a solid approval stamp. This is typical of financial services being complacent because no one ever questioned or thought that credit ratings could be so dramatically wrong and strewn with errors.
Even the regulators include credit rating checks within the due diligence required within banks and this practice must surely now be questioned. If the regulator is going to set such store in ratings, then surely the processes should be audited and approved, with the agencies duly regulated.
There is no doubt that the industry needs a vigourous and independent check on customers and counterparties but how valuable is this, if it is not transparent and there is no audited process. It looks now as though the banks have been relying on ratings, which quite frankly have not been worth the attention, they have been given.
The cost that banks and investing institutions pay the agencies for ratings appears to be flawed thinking! Ratings agencies look far from being unbiased and their findings have to be at the very least, somewhat questionable. Whose responsibility has it been to ensure that the ratings that are bestowed are genuinely independent and not simply bought?
Certainty in the finance industry is an important word and is used in cases of payment and delivery bringing assurity of settlement. Failure in these areas is a virus that penetrates the confidence of the market, leading to inertia.
The rating agencies have been an integral feature of the financial disaster as they created confidence in the counterparty and investor where none should have existed and systemic breakdowns rapidly lead to market stagnation and soon after the downturn. It is for this reason that ratings agencies have to take their share of blame.
The supply chain in financial markets is dependent on the confidence of delivery and payment built upon the surety of the supplier. As part of the recovery of the finance industry the rating agencies roles must be defined and their services measured against the importance the banks and their customers place on them.
So the ratings agencies must take some responsibility in creating the cosy environment that had a part to play in the enormous number of failures of respected banks. The complete loss of confidence between banks and their customers led directly to the retraction of credit and this has also lowered the benchmark for ratings. Is ‘Triple A’ worth as much today as last year? Does anyone have a ‘Triple A Rating’ now? Whatever the answer, the fact is that credit risk is now floating but with no rudder to steer it, without the complete recreation of credit ratings.
Credit risk is a risk we all thought we knew about but this crisis has now blown this fallacy apart. Financial institutions need to go back to square one and revert to more stringent in-house checks until the credit rating agencies create processes which ensure that their ratings can be taken with confidence and not with a pinch of salt.
* Gary Wright is an industry analyst and ceo of B.I.S.S. Research, a research firm and benchmarking service for the financial industry.