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Claire A. Hill
Professor of Law at University of Minnesota, US; founding director of the Law School's Institute for Law and Rationality, and the associate director of its Institute for Law and Economics.
Amid persistent concerns over European debt crunch and US economy's potential slowdown, economists feel discomfort about the abnormal rating agencies' activity that have downgraded a large number of countries and banks, spreading the overall anxiety. Dukascopy Bank decided to inspect the problem with an expert in this area, Claire Hill, Professor of Law, whose research interests include corporate governance, rating agencies and capital structure.
Why did rating agencies do such a bad job rating subprime securities? Conflicts of interest - responding to issuer pressure to give high ratings for fear of losing market share- is an important reason. But so is something less sinister, yet ultimately no less damaging: the agencies conceiving of their task as helping their 'clients,' the issuers, achieve the clients' objective of high ratings. The agencies have come under enormous criticism for their ratings of sovereign debt. But the story of sovereign debt ratings is quite different from the story of subprime mortgage securities ratings. Evidence of bad behavior (such as corruption of some sort, or problematic self-interest) may yet be revealed. But judgment calls were a big part of what happened. In retrospect, the judgment calls were clearly incorrect. They seem incorrect in prospect too, but hindsight bias may be influencing this assessment.
Many factors combine to make ratings potentially problematic, and make the rating agencies excellent distractions from a bad underlying reality. Rating changes are necessarily discontinuous while the phenomena they purport to describe are not. When a rating (of a country or a prominent company or issuance) is downgraded, the announcement will be quite salient, even though the underlying change may be quite small. Indeed, it is not clear whether rating agencies should take into account the effects of their ratings in deciding whether to downgrade. If they downgrade immediately upon a sign of trouble, they will make the situation worse, but if they do not and the trouble does not improve or even worsens, they will look foolish and be vulnerable to criticism. If they don't downgrade quickly and the situation improves, they will not be credited for their 'restraint.'
The rating agencies probably should have downgraded some sovereigns' debt sooner. But nobody was prevented from making his own assessment and concluding that the agencies were wrong, demanding higher interest rates for shakier countries' debt. The agencies have certainly proven that they can be wrong, sometimes dramatically so.
One important goal of rating agency reform is to reduce market reliance on ratings. Ratings should be only one input used in the broader process of appraisal: ideally, participants should not rely exclusively or even heavily on rating agency ratings. But it is not clear how to achieve this goal.
Certainly, removal of statutory and regulatory references to rating agency ratings is no panacea. No one has identified a good alternative measure of credit quality – if they had done so, reliance on rating agency ratings as assessments of credit quality, and their influence in the markets, would presumably have diminished without need for a change in law.
Moreover, removing statutory and regulatory references might further entrench the 'big 3' agencies, given their present dominance in the markets. An attempt to get markets used to other agencies' ratings, as was contemplated in the Franken amendment that was almost included in Dodd-Frank, might have helped in this regard. Increasing monitoring, oversight and liability of rating agencies is desirable, but its effect is likely to be limited.
But focusing on rating agency reform distracts from more urgent issues presented by the sovereign debt crisis. A significant contrast with the subprime crisis exists. Subprime securities were only marketable because of their high ratings. Had the agencies been unwilling to give the ratings, the securities would not have been created—nor, critically, would the mortgages which were the 'raw material' of the securities. The subprime crisis, and the financial crisis that has followed, thus importantly reflect (among many other things) the need for regulatory reform of the regime governing rating agencies.
The agencies' responsibility regarding the sovereign debt crisis is different. High ratings did, it is true, enable Greece and other presently troubled borrowers to incur very large amounts of debt. But in the Eurozone, the potential for grave difficulties, perhaps rising to the level of a crisis, has existed since the zone's inception.