"The reform of rating agencies is of course desirable, but difficult"
- Philippe Raimbourg
In light of the recent massive sovereign countries' and banks' rating downgrades, Dukascopy TV has interviewed and asked opinions on the role and importance of rating agencies of Philippe Raimbourg, Professor of Finance at University of Paris PanthГ©on Sorbonne.
1) A common society perception is that Rating Agencies have overlooked the financial crisis of 2008. Do you think that their current abnormal activity is an attempt to make up for past mistakes? Or they are just fairly doing their job?
"Abnormal activity", as I assume, is the referral to the sovereign state ratings. This activity does not look abnormal to me. For many European states, the level of indebtedness is high and it is normal that the rating agencies care about that. If we look carefully at the CDS' (Credit Default Swaps') of the first four European states that have been downgraded (Greece, Ireland, Spain and Portugal), we can see that this downgrades have been preceded by an uptrend of the spreads, meaning that the investors were waiting for such rating update. It seems the rating agencies are actually not the origin of the investors' mistrust of these four countries.
If the necessity for a review of the ratings is hard to challenge, it is also true that the evaluation of the sovereign risk is fairly difficult and I will not comment on the new rates. We can notice a very frequent divergence of views between different agencies regarding the same sovereign state. These details aside, I would answer positively to your question: what is the sovereign rating concerned, the agencies were doing the job during the last two years.
2) There are more and more pronounced attempts to regulate rating agencies. Do you think it is necessary? What is your recipe for effective regulation of rating agencies?
On the debts securities market, the mission of the rating agencies is not to inform on the credit risk of an issuer, but to confirm (or not) the appreciation that the investors may have on the credit risk of an issuer. The price and rate movements (expressing the investors' point of view) indeed generally precede announcements of rating agencies, whose function thus appears to certify that the movements in the price corresponds to a lasting change in the credit risk of the issuer to be sanctioned by a change in rating. This certification function is important because it prevents the development of rumours and mistrust sentiments on the part of investors not specializing in the concerning issues of the rating.
It is common to blame the agencies for their slow response and, perhaps to a lesser extent, the quality of their ratings. These criticisms are rooted in:
- The oligopoly of the international agencies,
- The conflict of interest, including remuneration mainly provided by the issuer,
- Lack of sanctions for evident errors.
The reform is of course desirable, but difficult.
In terms of the oligopoly, it may seem tempting to favour the emergence of new agencies. But such an approach would be successful only if the new agency acquires an international dimension, requiring much time and effort. More fundamentally, increased competition between agencies is not necessarily desirable because it could only lead to a worsening of the phenomena of "rating shopping", the fierce competition causing the weakest agencies to succumb to the temptation to over-rating.
It seems preferable to provide investors with a benchmark close to the rating but different from it. For instance, in France the Central Bank has successfully developed a scoring system for companies unlisted in the financial markets. We can imagine that other institutions, based in particular on academic research, support the development and dissemination of assessments of statistical nature of the risk of issuers. That would be an alternative to the rating.
Out of ten agencies registered in the U.S. (NRSROs), only three use the system subscriber-payer. Due to the very simple means of duplication and circulation of information among investors, it seems impossible to develop this system of remuneration.
However, we can reduce the risk of over-rating resulting from the issuer-payer system. These risks are particularly important in securitization, since the agency even participates in the development of financing and rating. The idea of an intermediary whose function is to assign each issuer to an agency has already been discussed. It would make "rating shopping" impossible and would probably help the agency to better withstand any pressure from the issuer.
Finally, concerning the responsibility of the agency, it can only refer to the method (and not the results) of the rating process, as their work is largely based on a forecast of cash flows of the company/country, and the error is inseparable from any forecasting work. It would require the methods and techniques necessary for a satisfactory analysis of the credit risk to be pre-defined. This control should be accompanied by the monitoring of the rating agency activity to better understand the impact of its activity in the financial markets.
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?
No, I do not agree with neither one nor the other of these two statements.
Concerning the validity of the financial theory, we must distinguish the concept of its application. Affirmation of the existence of a risk-free rate, and consequently admit that the rate of return of an asset is divided into a risk-free rate and risk premium, mainly allows sorting out the problems. Determining the risk-free rate refers to the preference for the present moment and the risk premium refers to the analysis of the risk. Before any question of measurement, this approach, central to financial theory, had grounds in the past and still has today.
Financial theory has an operational goal and is designed to be applied, so its main concepts are to be quantified and measured. This is often tricky. For example, let us have a look at the risk-free rate: since the beginning of the crisis in 2008, that is to say, before the deterioration of some sovereign ratings, the interventions of the central banks in currency markets were of such magnitude that the observed rates were very low. Were they reflecting the preference for the present? Many analysts were sceptical and were encouraged to retain the value of risk-free rates that prevailed before the crisis.
Now some countries, including the United States, have been downgraded. However, we should note that the agencies have different views on the North American sovereign risk, that the increased risk estimated by Standard and Poor's is very low and corresponds before the crisis to a spread of about 10 to 15 BP, and finally that the German bonds are still rated AAA. The measure of the risk-free rate that will be made will certainly be imperfect, but probably no more difficult than in 2008.