- Francesco Franzoni, Assistant Professor of Finance at University of Lugano and Junior Chair at Swiss Finance Institute
In light of the massive countries' and banks' ratings downgrades by the major rating agencies the analysts are trying to recognize the real meaning behind the downgrades, whether they signal the global economy's slowdown or endeavour to fix their image for relative sluggishness during the crisis of 2008. In this respect Dukascopy has asked expert's opinion on the role and importance of rating agencies.
1) The majority of analysts state that the rating agencies have failed to notice the financial crisis of 2008. Do you think that their current abnormal activity is an attempt to make up for past mistakes?
The Rating Agencies are one of the culprits, among many others, of the financial crisis of 2008. Their collusive behavior with the issuers of the toxic assets contributed to conveying a sense of safety to investors in these securities. The conflict of interest was manifest, as they were paid by the same firms that they were supposed to rate.
The situation has not changed. The conflict of interest remains. And these agencies have not paid for their role in the crisis. I agree that their current activity seems to be a response to the criticism that they had received. It appears that their current strategy is to preempt future. It feels as if they are saying: "Look, you blamed us for being too lax on the toxic assets... Now, we have reformed ourselves and our criteria are much more stringent... Thus, no intervention is needed". But, as I said, there is an intrinsic problem with the way they operate. They need to be reformed.
Finally, the market does not seem to put much weight on their downgrades. Rather, their judgment follows in time the market's changes of opinion. Once again, the Rating Agencies are not performing a useful role.
2) Do you consider that regulation of the agencies is necessary? What is your recipe for effective regulation of rating agencies?
This is a difficult question. I do think that they need to be regulated. The direction to go is not clear, though.
Having rating agencies that are a subject to the Governments or to some political bodies, such as the EU, is not the best idea to solve the conflict of interest. Their ratings would not be unbiased. An element of political considerations would always come to bear on their judgments. The governments would certainly lobby the agencies not to have a downgrade on their debt. If the agencies were public institutions they could not withstand the pressure from the Government. Hence, this does not seem to be the right solution.
Rather, one could envisage a solution in which the rating agencies remain independent companies. Their fees would be paid through a fund to which all issuers of debt or related securities are obliged to contribute. It is similar to the situation when all banks have to pay a premium for deposit insurance, or insurance companies contribute to a fund that guarantees their policies in case of failure of one or more insurers.
Moreover, I do not see why the rating agencies should not be exposed to more competition. To foster competition in this sector, there should be public information about the performance of these companies in doing their business. Their score should be periodically assessed. This is something that a public body could do. I understand that it takes time to establish a reputation in this sector and that new rating agencies will not emerge tomorrow. Nevertheless, the market should be open for new firms that want to prove themselves. Thus, the regulators should also publish the scores of smaller rating firms that make effort of getting into this business. Finally, when designing the regulation, such as banking regulation, it should be made explicit that the acceptable risk assessments are those of the rating agencies that have performed best recently.
3) We have seen some unprecedented downgrades so far lead by US that lost its AAA rating from S&P. Do you agree that the world has officially lost its risk-free benchmark and the financial theory is not working any more?This is also a hot topic. I would not go so far, however, as to say that there are no more risk-free securities. Recent market trends have shown that U.S. and German Government bonds were in high demand during the flight to quality of the past weeks. So, the market still considers some securities as riskless, or less risky. Perhaps I am going against the tide, but I think that we should not consider the event of a default (of any kind) of the U.S. as even possible. If anything like that ever happened, it would be the time when we would have to think of different models not just for finance, but for the economy, and the society at large.