Reducing Dependence on Credit ratings would Aid Markets under Basel Risk Management System
The economics of developed and less-developed countries are now turning around. Even though there is some notice that we need to wait during at least one quarter to get a clearer idea of whether sluggish consumption is turning around, in my opinion, known by the discussion about exit strategy, our economic is in the boom state now. Coincided with this positive anticipation of economies, there are many voices that we must find out the cause of recent financial crisis and make properpolicies to prohibit the recurrence of the accident. In this view, IMF’s Global Financial Stability Report, issued at September 29, 2010, can be a very good and key reference to see what causes the recent global crisis, especially about credit rating system.
How can credit ratings be a bomb to financial market at the crisis?
Credit ratings are the indices which measure the relative risk that an entity such as a government or a company will fail to meet its financial commitments and play a significant role in certifying the quality of investments in fixed-income markets. The analysis, in the IMF’s Global Financial Stability Report, says that ratings have inadvertently contributed to financial instability. This recommends that regulators reduce their reliance on credit ratings as much as possible and increase their oversight of the agencies that assign the ratings used in regulations. Then, through what channel, credit ratings can have an effect to economy?
Regulators, for example, rely on ratings in setting standards for securities that financial institutions hold. Institutions must hold less capital to buffer against losses on higher-rated assets than on lower-rated ones. Central banks often rely on credit ratings to determine what securities they will accept as collateral on loans to bank or other financial institutions. Ratings play similar roles in private financial dealings, when securities are posted as collateral and private financial contracts often contain ratings triggers that end credit availability or accelerate a borrower’s credit obligation if a downgrade occurs.
Now, we can know that credit ratings are very important to our economies and it effects through many channels and agents in economies. We may wonder that although credit ratings are accurate enough, is it matter to rely on credit ratings when we have many transactions? The answer is, unfortunately, yes.
Rating accuracy&Basel Risk Management
The major rating agencies—Fitch, Moody’s, and Standard & Poor’s—do not target their ratings to the specific probability that an issuer will default. Instead they seek to provide only relative rankings of credit risk—that issuers in a lower grade are more likely to default than those in a higher grade and less likely than those below it.This way is not only plausible, but also does a pretty good job. The IMF report finds that the rating agencies do very well meeting that goal. For example, all of the sovereign debt that has defaulted since 1975 had received speculative-grade ratings one year ahead of their default. In other words the defaulting debt was concentrated in the lowest credit ratings.
The rating agencies also aim to ensure that ratings do not change frequently, because users prefer to avoid the costs associated with frequent policy changes and investment decisions linked to ratings. The rating agencies minimize ratings changes by judging an entity’s ability to survive a cyclical economic trough and by additionally applying various rating-change smoothing rules.But the IMF report says that these added smoothing techniques often have an opposite effect from what was intended. Typical smoothing rules sometimes merely delay inevitable downgrades that become more abrupt and cliff-like if the situation has continued to deteriorate.
The aversion to rating volatility relates to the myriad ways in which ratings are embedded in investment guidelines and eligibility standards for securities used as collateral or investment.Most of credit rating systems depend on transition matrix, which shows the probabilities from the previous crediting grades to current grades to calculating bank capital requirements known as Basel. With smoothing techniques, the transition matrix has some problems in the crisis state. Actually, Risk management system has elaborated to care about the crisis state. The trials, to reduce the disturbance in normal states by smoothing probabilities, increase the chaos in crisis state, not being the very present help in time of need.
To reduce the potential cliff effects in spreads and prices that rating changes can trigger, the IMF recommends the elimination of regulations that formally link buy or sell decisions to ratings, as some countries already have done. The IMF report also says that cliff effects could be mitigated if rating agencies refrained from using smoothing rules that effectively delay rating changes.Reducing rating overreliance will require better fundamental credit analysis by users, and it will be important that the authorities remain wary of unintended adverse consequences. Moreover, policymakers pushing to reduce rating reliance should recognize that smaller and less sophisticated investors and institutions will continue to use ratings extensively.
Recently, Basel III has promulgated. As we all know well, institutional reform means providing a stronger framework within our financial markets can operate. Robert J. Shiller compared this situation to train.
“No matter how powerful and technologically sophisticated the train, it is only as good as the track on which it runs.”
Regulatory and insurance institutions are the track that carries our financial markets. Although we develop the state of art techniques to calculate bank capital requirement under Basel III, we cannot guarantee our success in finance market if we cannot handle fundamental problem, overreliance on credit ratings.Thus, before meeting crisis again, we should all draw on our wisdom.
By Kyongchae Jung (firstname.lastname@example.org)